REGULATION OF THE GOVERNMENT SECURITIES MARKET

Report by the Securities and Exchange Commission to the Subcommittee on Telecommunications, Consumer

Protection and Finance of the Committee on Energy and Commerce of the U.S. House of Representatives

JUNE 20, 1985

EXECUTIVE SUMMARY

I. Response to date by the market, investors, state and federal regulators and dealers to the ESM and BBS failures.

A. Market Response:

1. Acting Assistant Secretary of the Treasury Niehenke testified at the open SEC meeting that the failures have not had a perceptible adverse impact on the cost of financing of the national debt.

2. Some commentators have indicated that some inves­tors have withdrawn from the government and repo market, especially the GNMA repo market.

B. Many investors are:

1. perfecting their security interests in repos;

2. not providing excess margin in reverse repo transactions;

3. limiting their dealings to better known and capitalized dealers, particularly regulated or primary dealers.

C. Regulatory bodies have taken the following actions:

1. The Federal Financial Institutions Examination Council has proposed, and the FRB and FDIC have adopted, guidelines for securities lending activ­ities requiring adequate collateralization.

2. The FHLBB has rearticulated its investment guidelines for savings and loan associations and is considering requiring securities and underlying repos to at least equal the value of the repo, possession or third party control of these securities, dealings only with regulated broker­dealers, and frequent marking-to-market of securities.

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3. Municipal investment regulators, such as the NY State Comptroller, the State of New Jersey, and a number of municipalities, have issued or are considering issuing strict standards requiring possession or third party control of securities underlying repos, limiting the dealers that can be used, or prohibiting repose

4. The FRB has issued voluntary capital adequacy guidelines, stepped up its visits to dealers, and issued educational materials, such as "Its 8:00 a.m. -- Do You Know Where Your Collateral Is?" Individual Federal Reserve Banks are holding educational seminars for investors.

5. The SEC has recently brought enforcement actions against certain government securities dealers and individuals associated with those dealers; is investigating the conduct of other persons who were affiliated with those government securities dealers; and is conducting examinations of certain governnment securities dealers who have voluntarily agreed to the examinations.

6. It has been reported that other federal and state law enforcement authorities' are examining the conduct of certain government securities dealers and persons associated with those dealers.

7. The SEC Division of Investment Management has reiterated to all investment companies the need to perfect and maintain a security ihterest in

,,>.' • repos (i. e., the need to take possession of securities and to mark them to market).

8. The SEC Chief Accountant's office and Division of Corporation Finance are preparing a proposed release which would require greater disclosure of repo activities and risks by registrants.

9. The AICPA has formed a task force to address repo auditing issues. The Government Accounting Standards Board and the AICPA are also working on repo disclosure projects. These initiatives

" have occurred under SEC oversight.

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II. The FRB, Treasury and SEC differ somewhat in their views of the necessity for legislation. If Congress concludes that additional legislation is to be enacted, they would find the following approach acceptable.

A. All currently unregulated dealers in Treasury or government-sponsored agency securities to be registered ... Information on these dealers to be accessible to all relevant regulators. The SEC and the Treasury differ as to which should be the registr~r.

B. The SEC and the bank regulators to be granted the authority to provide sanctions against or to bar those who violate either the securities or the banking laws.

C. The Treasury, in consultation with the FRB, to be granted authority to adopt rules as necessary on:

(1) capital,

(2) independent audit and recordkeeping,

(3) collateralization (e.g., segregation or del.:j. very requirements), margin·, and when~

. issued trad.:j.ng practices.

D. (1) All government and agency securities dealers to be subject to C(3);

(2) 'Presently unregulated dealers to. be subject to C(l) and C(2) as well;

(3) All others to,. continue to be subject to SEC or banking agency capital and recordkeeping requirements.

E. Inspection and rule enforcement of

(1) non-bank dealers by existing self-regulatory organ­izations, under SEC oversight, including inspections;

(2) bank dealers by banking agencies.

III. FRB to continue to exercise surveillance over primary dealers.

IV.

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While the Commission has not conducted a formal cost­ben~fit analysis, if legislation is to be enacted the Comnrl:s'slon ,recommends,,,the' following apprQ~ch. "

... ':.',

·'·"',.r.--., " .. ' .

A. All"ctirrEmtly. unregulated dealers in"T:t;.~~sury or "":',,>'

B.

C.

:,government-sponsored agency securities to 'be registered with the SEC~' 'Information on these dealers to be ,,,,'"","" accessible to all relevant regulators.

The SEC and the bank regulators to be granted the authority to provide sanctions against or to bar those who violate either the securities or the

'l?,anking laws. "I' .~., ." ..... ,~

• , , .~ '. . • ",', ," t,!';"' 'I . ••• •• ' • ••• • " " ,1';,_

The Treasury, in' consultation with"the FRB, to be""" granted authority to adopt rules with respect to currently unregulated dealers in Treasury or government-sponsored agency securities as necessary on:

(1) capital,

(2) independent audit and recordkeeping.

D. All others to continue to be subject to SEC or banking agency capital and recordkeeping requirements.

E. Inspection and rule enforcement of '. "'("

'/

(1) non-bank ,dealers by existing self-reguI'atory organizations, under SEC oversight, including

"'c"inspections:

(2)'bank dealers by banking agencies. ~ .. '

'·,F,., ' FRB ;'t.o continue to exercise surveillance over pz:imary dealers.

'" 't, ) ....... :

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I. Introduction

On March 21, 1985, the Securities and Exchange Commission

indicated in hearings before the Telecommunications, Consumer

Protection and Finance Subcommittee of the House Energy and

Commerce Committee that it would review the government securi-

ties market in the wake of recent government securities dealer

failures, in consultation with the Federal Reserve Board

("FRB") and the Department of the Treasury, and advise Congress

whether it believed additional regulation is needed, and if

so, the most cost-effective approach. To this end, the

Commission has (1) issued a release seeking public comment

on reactions in the marketplace, the need for additional

regulation of the government secu'ri ties market, if any, and

if so, the cost and benefits, -1./ (2) conducted extensive

interviews with government securities investors'and dealers,

and (3) held an Open Forum to obtain directly the views of

representatives of investors, dealers, industry. groups,. and

regulators.

This report reflects the views of the Commission,

developed in consultation with the FRB and the Treasury.

The FRB, Treasury and SEC differ somewhat in their

views of the necessity of legislation. If Congress concludes

that additional legislation is to be enacted, they would

find acceptable the proposal outlined in Parts II and III of

the Executive Summary.

.-l/ securities Exchange Act Release No. 21959 (April 19, 1985) ("April Release"). A copy of this release is attached as Exhibit 1.

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A. Problem Incidents in the Government Securities Markets

The market for government securities ~/ is by far the

world's largest and most efficient securities market. The

monthly trading value of just the 36 primary government dealers

that report to the FRB amounts to over $1.5 trillion -1/ or

approximately 15 times the volume of all transactions in corporate

securities traded on all the nation's securities exchanges and

.over-the-counter markets. ~/ This highly liquid, keenly ~'-.... ;:.' .

competit~ve market operates largely on the basis of confi­

dence in the integrity and financial soundness of the market

participants. Government securities dealers are a pivotal

element in this market, facilitating the distribution of the

-1./

.-!/

In referring to government securities, the Commission includes both securities sold by the u.S. Treasury ("Treasury securities"), and securities issued or gua­ranteed by government or government-sponsored agencies ("agency securities"), such as the Government National Mortgage Association ("GNMA"), Student Loan Marketing Association, and Federal Horne Loan Mortgage Corporation ("Freddie ~lac").

Office of the Secretary, Department of the Treasury, Treasury Bulletin, 1st Quarter, Fiscal 1985. Of this amount, $1.247 trillion was in marketable Treasury securities •

Based oriSEC Statistical Review, February 1985, Table M-llO, and NASD 19~4 Annual Report. These figures are not directly comparable because of differences in the way dollar volume is calculated in these markets.

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increasing amounts of government debt offered to investors,

and providing continued liquidity with respect to investments

in these securities.

Dealers finance their government securities activities

with their own capital, term and bank loans and repurchase

agreements ("RP"). -.2..1 Dealers also use reverse repurchase

agreements ("RRP") ~/ to obtain securities and match with

RP's that exceed those needed to finance inventory. Through

these means, government securities dealers have had remarkable

success in purchasing and placing increasing amounts of

government ·debt.'

~/ A RP is an agreement to sell securities with a commit­ment to repurchase the same securities from the buyer at a future date. Buyers 'in RP transactions generally view RPs·as investments carrying little risk. In practice, the buyer in a ,RP transfers cash to a seller and:receives securities (or has securities held on its behalf) as "collateral," and the seller agrees to repurchase the securities' for the cash plus interest at a future date.

~/ A RRP is an agreement to buy securities with a commit­ment to resell the same securities to the seller at a future date. In effect, RRPs and RPs are two sides of the same transaction, and sometimes are referred to collectively as RPs in the discussion that follows.

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The failures of several small government securities

dealers, -21 which have resulted in alleged losses of about

$900 million to investors since 1977 (before taxes, insurance

and civil suit recoveries, if any), have raised questions

about the need for some form of oversight. These dealer

failures occurred for a variety of reasons, including apparently

normal trading reverses, ~I the transfer of large losses

from affiliates, improper use of ac~ru'ed interest ~I and

-21

~I

...:!..I

These failures (or near failures) included Winters Government Securities, Inc. (1977), Hibbard & O'Connor Government Securities, Inc. (1982), Drysdale Government Securities, Inc. ("Drysdale") (1982), Comark, Inc. (1982), Lombard-Wall, Inc. (1982), Lion Capital Group, Inc. ("Lion") (1984), RTD Securities, Inc. (1984)" ESM Govern­ment Securities, Inc. ("ESM") (1985)j Bevill Bresler Schulman Asset Management Corp. ("BBS") (1985), and Parr Securities Corp. (1985). For further information on several of these failures, see Statements of John S.R. Shad, Chairman of the Securities and Exchange Commission, to the Subcommittee on Commerce, Consumer and Monetary Affairs of the House Committee on Government Operations, Concerning the Government Securities Market, (April 13, 1985) and (May 15, 1985). See also text at note 16 infra (Brokers Capital, et al.).

~, Lombard-Wall, Inc •

~, Drysdale.

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the fraudulent use of customer securities and margin payments. 10/

In several of these instances, RP customers found upon the

failure of the firm in question that the securities subject

to repurchase had been used in other RP transactions, 11/ or

that the value of securities subject to repurchase had declined.

In addition, RP customers that had provided excess margin

lost the difference in value between the securities provided

as margin for RP transactions and the cash received. ~/

Among the more prominent of these failures were Drysdale,

Lion, ESM, and BBS. In the first of these situations, Drysdale

(and later an affiliate formed to conduct its government securi-

ties activities) sought out securities with accrued interest

for RP trades. Because customers did not take irito account accrued

interest in valuing securities in RP transactions, Drysdale

was able to use such accrued interest to finance its operations.

10/ The failures of Winters Government Securities, Inc. and Hibbard & O'Connor Government Securities, Inc., allegedly involved sales practices abuses, including misrepresentations of the risks and terms of investment of securities, unsuitable recommendations, and high pressure sales techniques.

~, ESM, BBS, Lion, and Comark, Inc.

12/ ~, ESM and BBS.

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. Ultimately, however, Drysdale was responsible for pay'ment of

the interest, and when it was unable to do so, its customers

incurred approximately $300 million in alleged losses before

recoveries, if any. The Drysdale failures resulted in the

market, under the leadership of the Federal Reserve Bank of

New York ("FRBNY"), taking accrued interest into account in

RP trades.

The failure of Lion in 1984 resulted in alleged losses

before recoveries, if any, of approximately $40 million to

about 60 institutions. Many of these institutions allegedly

had engaged in RP transactions after receiving rate quotations

from a money broker. In many cases, customers allegedly

believed that the securities subject to repurchase were he'ld

on their behalf by Lion's clearing agent, when in fact that

clearing agent claimed after Lion's failure that it was

holding those securities as security for loans to Lion rather

than in trust for Lion's customers. The Lion failure, together

with other failures, resulted in legislation to clarify the

status of RPs in bankruptcy.

ESM, an unregistered government securities dealer located

in Fort Lauderdale, Florida, failed in March 1985, with alleged

losses, before recoveries, if any, of over $300 million to

institutional investors. 13/ It is alleged that, although ESM

13/ April Release, supra note 1, at 16.

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incurred $38 million in trading losses and $32 million in

operating expenses in 1984 (with comparable losses and

expenses in previous years), it was able to continue to

transactRPs by fraudulently fai+ing to reflect these

lQsses in its financial s~a,tements,~ 14/ It is also alleged

by the ESM receiver that about $200 of the $300 million of

ESM losses were incurred by two savings and loan associations

("S&Ls") controlled by the same individual. 15/

It appears that the remaining $100 million of losses to

ESM customers in RP transactions occurred largely because

these customers had failed to obtain possession or otherwise

perfect a security interest in the securities underlying the

RP. Customers allegedly were told that their transactions

were secured and that securities were being held in safekeeping

by ESM's clearing agent for their benefit. ESM's clearing

agent has stated that it held these securities as collateral

for: loans-to ESM. Losses by the two S&Ls in RRP transactions

with ESM apparently resulted from their providing ESM with

margin greatly exceeding the cash received for the securities.

14/ Report on the Condition of ESM Companies by Thomas Tew, Receiver, SEC v. ESM Group et. al., Case No. 85-61 civ­Gonzalez, In the U.S. District Court (S.D.Fla. April 2, 1985). These losses allegedly were disguised by transfers between ESM and an affiliate.

15/ Id.

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Upon the'failure of ESM, they were left with claims for

the difference between the market value (including accrued

interest) of the securities sold to ESM and the amount

received for these securities.

BBS, an unregistered government securities dealer located

in New Jersey, failed in April 1985, with alleged customer

losses of as much as $235 million, before recoveries, if any.

It is alleged that BBS fraudulently entered into RPs without

proper collateralization in order to finance large trading

losses incurred by an affiliated unregistered government

securities dealer. It is also alleged that a registered

broker-dealer affiliate (which has been placed in SI·PC

liquidation) solicited government securities transactions

which were placed with BBS.

RP customers of BBS, including S&Ls, banks, and other

dealers, suffered losses for similar reasons as in ESM: they

found the securities underlying their transactions were claimed

by other parties, and their purportedly secured RPs were in

fact unsecured. It appears that in many instances government

securities purportedly held for the benefit of customers had

been resold or otherwise converted by BBS. Losses also were

sustained by RP customers that had provided excess margin.

As a result of their dealings with BBS, three small government

securities dealers, Brokers Capital Ltd., Midwest Government

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Securities, and Collins Securities Corp. incurred alleged

aggregate losses of about $9.7 million and failed or were

liquidated. 16/

B. Commission Review

In response to the ESM and BBS failures, and in order

to provide Congress with its views on regulation of the

government securities market, the Commission reviewed the

background of the recent problems and the market responses to

these problems through· several means. Commission staff

members, in preparation for the Commission's Open Forum

discussed below, contacted by telephone over two dozen investors

in the government securities markets, including municipalities,

credit unions, S&Ls, and investment companies, and interviewed

in person approximately twenty primary and secondary dealers

in government securities. The staff sought information

concerning any problems these market participants had observed

as a result of the ESM and BBS failures, their individual or . '

any general market responses to these problems, and their

views on the question of additional oversight of the gov~rnment

securities markets. Commission staff also conducted telephone

inspections of the RP practices of 292 investment companies.

16/ For further details on these failures, see Statement of John S.R. Shad, Chairman of the Securities and Exchange Commission, to the Subcommittee on Commerce, Consumer and Monetary Affairs of the House Committee on Government Operations, concerning the Government Securities Market (May 15, 1985).

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In addition, the Commission, on April 19, 1985, pub-

lished a release requesting comments on reactions in the

marketplace to the widely-publicized ESM and BBS failures

and the form, costs, and benefits of any recommended additional

federal regulation of government securities dealers. Seventy-

nine comments have been received to date. 12/ To further

obtain the views of market participants regarding these

questions, the Commission on May 21, 1985, held a full

day Open Forum, consisting of panels representing investors,

primary dealers, secondary dealers, industry groups, and

regulators. 18/ In addition, the Commission has consulted

with the Treasury and FRB and received the results 'of dealer

surveys 19/ compiled by both agencies. These sources provided

considerable information on the response of the market to ESM

and BB~ and contributed materially to the Commission's analysis

regarding regulation of the government securities market.

17/ A summary of these commerits is attached as Exhibit 2.

18/ A summary of the views expressed by panelists at this Open Forum is attached as Exhibit 3.

19/. The FRBNY has conducted an informal survey of the effects of recent market developments on govern­ment securities dealers, and has been collecting information on the dealers active in the government securities market. 'l'he Treasury also conducted an informal survey of the market practices in the RP market.

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c. Market Response

In reviewing the market response to the ESM and BBS ,

fai lures, Acting Assi'stant Secretary of the Treasury (Domestic

Finance) John J. Niehenke testified at the Commission's Open

Forum that the ESM and BBS failures have not had a perceptible

adverse impact on the cost of financing of the national

debt. 20/ Other commentators, howeve'r, indicated that these'

failures have led some investors to cease trading in the

government securities market and that the long-term effect

of these failures could lead to a contraction in the dealer

community, thus decreasing liquidity. One commentator also

suggested that this contraction could increase Treasury

financing cost's. 21/

In considering the problems raised by ESM and BBS,

it also is important first to note that the improper practices

which occurred in those cases do not reflect standard practices

in the government securities market. A survey by the Treasury

Department indicates tha.'t in February, prior to ES~l, respondents

delivered to investors or heid in third party arrangements

approximately 86.9% of the dollar value of RPs on Treasuries

and 33.3% of the dollar value of RPs on other collateral

20/

:?:J:./

Statement of John J. Niehenke,Acting Assistant Secretary for Domestic Finance, Treasury Department, at the Commission Open Forum (Transcript at 206, 218) ("Niehenke Statement").

See letter from Ronald D. Upton, Executive Vice President Irving Trust, to John S.R. Shad, dated May 17, 1985, at 7 ("Irving Trust Letter").

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( e • g., GNMAs). 'I,;,'

I'tl"addi tion . ! most dealers that. maintained

custody of the securities in aRP transaction properly 'I',

segregated those se'curi ties from their proprietary

account.

Moreover,.each of these recent dealer failures involve

RP activities and not trading or sales practice abus~s in the

secondary market for government securities. In light of

government securities dollar trading volumes well irf/excess'

of $1 trillion per month, this'absence of identified 'abuse is

impressive.

With the exception of the registered securities affiliate

of BBS, none of the fraudulent activity identified relates to

any of the primary dealers or registered securities or bank

dealers. ,Therefore, while the failures of ESM and BBS were

significant, they were "fringe" participants in the government

securities market.

The highly publicized ESM and BBS failures have prompted

the following responses by institutional investors dealers,

state and federal regulatory bodies and others.

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With respect to investors, it is important first to note

that, unlike the market for corporate and municipal securities,

the government securities market is primarily institutional.

Accordingly, while some of these investors may not be as

sophisticated as many institutional investors, the nature of

the government securities market is different than the markets

for other securities. As to the reaction of these investors, .

they generaliy have shown greater caution in their investment

practices. Some investors have withdrawn from the government

securities market or the RP market, choosing to accept lower

returns for what they perceive as safer investments. 22/ For

example, Beaumont, Texas, which suffered losses of approximately

$20 million in the ESM collapse, now restricts its investments

to deposits in local banks and S&Ls. ~/

~/ See,~, letter from Danny O. Crew, Assistant City Manager, City of Pompano Beach, Florida, to Michael Simon, Assistant Director, SEC, dated May 17, 1985i letter from S. Waite Rawls, III, Managing Director, Capital Market Group, Chemical Bank, to John S.R. Shad, Chairman, SEC, dated May 17, 1985, at 4i letter from James W. Thompson, Corporate Executive Vice President, NCNB National Bank, to John S.R. Shad, Chairman, SEC, dated May 17, 1985, at 2.

~/ Statement of Betty Dunkerley, Acting Finance Officer, City of Beaumont, Texas, at Commission Open Forum. The Commission contacted 11 investors that had ex­perienced problems in dealing with ESM and BBSi of these, 10 have withdrawn from the RP market.

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A number of commentators and panelists at the Commission's

Open Forum noted that many investors have begun a "flight to

quality." 24/ Some.have chosen to deal only with dealers

recognized as "primary dealers" by the FRBNY, 'f.2/ instead of

making independent determinations of the capital adequacy and

credit worthiness of dealers. Other investors have restricted

their dealings to "regulated" dealers, such as primary dealers,

banks, and registered broker-dealers having a specified

minimum capitalization, ~, $100 million. 26/

Many investors also appear to have responded to ESM and

BBS by taking steps to ensure that they have a security interest

24/

25/

26/

See, ~, letter from John E. Haupert, As·sistant Director, Finance Department, 'l'he Port Authority of NY & NJ, to John Wheeler, Secretary, SEC, dated May 17, 1985: letter from L.N. Wesley, Jr., Senior Vice President-Finance, Sears Savings Bank, to John S.R. Shad, Chairman, SEC, dated May 20, 1985.

The FRBNY recognizes 36 government securities dealers as "primary dealers" with whom it deal in its open market operations. These dealers consist of 13 banks, 12 registered broker-dealers, and 11 unregistered dealers (5 of which are affiliated with registered broker-dealers). The FRBNY has emphasized that desig­nation as a primary dealer should not be taken by investors as an FRBNY endorsement of these firms' creditworthiness.

The Commission contacted 11 investors that had not experienced problems with BBS and ESM, in addition to the 11 above mentioned "victims". See note 23, supra. Four of these investors indicated they had recently changed investment policies, including restricting the dealers with whom they would deal to more familiar dealers.

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in the securities in RP transactions. ~/ Most frequently,

these investors take possession of the Treasury securities

underlying the RP through an independent custodian bank,

even though this results in wire transfer and custodial

charges that can reduce the yield in a RP transaction. 28/

Delivery of the securities also has been facilitated by the

increasing availability of so-called "third party" RP arrange-

ments, 29/ in which a custodian bank acts as agent for both

the dealer and the customer, making account entry transfers

of the securities subject to repurchase from the dealer's

account to the customer's account in RP transactions. In

addition, there appears to be an increasing tendency for

market participants to monitor more actively the securities . .

underlying the RP transactions. 30/

Dealers apparently have responded to ESM and BBS with

increased care in making credit evaluations of contra parties

in transactions, and in obtaining perfection of a security

:£l/

28/

29/

30/

See letter from Howard Whitman, Senior Executive Vice President, Thomson McKinnon Securities, Inc., to John Wheeler, Secretary, SEC, dated May 17, 1985: letter from JamesW. Ogg, President, Westcap Corp., to John Wheeler, Secretary, SEC, dated May 8, 1985.

Certificated securities such as GN~~s, however, cannot be wire-transferred.

See Irving Trust letter, note 21 supra.

Id.

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interest in RP transactions. 31/ They also appear to have

reduced their RP activity, although this is at least partly a

result of lower investor RP demand. 32/

This increase in institutional investor and dealer caution

in response to ESM and BBS has been supplemented by actions of

regulatory bodies and industry groups. Educational efforts

have begun, with the publication by the Public Securities

Association of a booklet, IIBusiness Practices Guidelines for

Participants in the Repo Market ll in 1982, and the recent pub-

lication by the FRBNY of its cautionary brochure, lilt's 8:00

a.m., Do You Know Where Your Collateral Is? II In addition, the

FRB, through the Federal Reserve Banks, is holding investor

educational forums on the government securities market around

the country. These efforts are intended to acquaint market

participants with the risks and available safeguards for RP

transactions.

Enforcement actions also have been brought against certain

government securities dealers, thus highlighting for the investment

community the need for care in their dealings. The Commission

has brought enforcement actions against several government

securities dealers; 33/ is investigating the conduct of

other persons who were affiliated with government securities

B./ Letter from S. Waite Rawls, III, Managing Director, Capital Harket Group, Chemical Bank, to John S.R. Shad, Chairman, SEC, dated May 17, 1985; letter from Robert P. Mulhearn, Managing Director, Morgan Stanley & Co., to John S.R. Shad, Chairman, SEC, dated May 17, 1985~

Id.

Actions have been brought in the ESM (SEC v. E.S.M. Government Securities, Inc., et. al., No. 85-6190 (S.D. Fla.» BBS (SEC v. Bevill Bresler & Schulman & Co.s 85-3451 (S.D.N.Y», and Parr Securities (SEC v. Parr Securities Corp., 85-1715) (D.N.J.» failures.

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dealers: and has conducted examinations of certain government

securities dealers who have voluntarily submitted to such

examinations. Other federal and state law enforcement autho-

rities reportedly are examining the conduct of certain government

securities. dealers and persons associated with those dealers.

Other regulatory agencies have taken additional steps to

help ensure careful investment by regulated entities. The

Federal Financial Institutions Examination Council ("FFIEC"),

consisting of the FRB, the Federal Deposit Insurance Corporation

("FDIC"), the Federal Home Loan Bank Board (FHLBB"), the National

Credit Union Administration, and the Office of the Comptroller

of the Currency, has recommended guidelines for securities

lending activities by regulated institutions. 34/ These

guidelines have been adopted by the FRB and FDIC. In addition,

the FHLBB has in place guidelines governing government

securities transactions for S&Ls regulated by the FHLBB or

insured by the Federal Savings and Loan Insurance Corporation

("FSLIC"), ~/ and the FHLBB is considering adopting additional

34/ These guidelines indicate that securities should not be lent unless cash or other collateral has been delivered to the lending institution or a third party trustee before or at the time the loan is made. They also support a minimum initial collateral of 102% of the market value of lerit securities plus accrued interest. They further support credit committees, credit limits, and maintenance of a daily recordkeeping and reporting program.

~/ These guidelines include requirements that S&Ls (1) know the dealer before engaging in any government securities transactions, (2) inspect the certified financial statements and other filings required by any agency that· regulates the dealer, (3) do a credit analysis of counter parties, (4) use capital adequacy guidelines in choosing dealers, (~) ensure that an adequate security interest in collateral exists, and (6) review RPs to see if the market value of the securities exceeds funds received.

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guidelines that would, among other things, require S&Ls to

deal only with "regulated" dealers, obtain possession or use a

third party depository arrangement for control of the securities

underlying RPs, and ensure that they received securities at

least equal in value to funds they provide in RPs. 36/

In additi.on to these actions by federal agencies, certain

states and localities have drawn up or are preparing guidelines I.' ..• •

to guide investments, including RPs, by government bodies.

For instance, the Office of the New York State Comptroller

distributed guidelines requiring, among other things, that

local governments perfect security interests in their RPs by

having the local government or its agent obtain possession of

the securities, and that local governments deal only with

"regulated" dealers. ll/ New Jersey is considering similar

investment policies and it appears that on the local level

explicit policies governing investments are being developed. 38/

36/

"ll/

38/

Letter from Norman Raiden, General Counsel, FHLBB, to John S.R. Shad, Chairman, SEC, dated May 20, 1985.

See Cash Management and Investment. Polici~~;o~and Procedures for use by Local Government Officials (Office of the N.Y. State Comptroller, December 1984). These guidelines were adopted primarily in response to the losses suffered by many New York school districts and municipalities in the Lion and Lombard-Wall failures. The Office of the N.Y. State Comptroller argued that federal regulation of government securities dealers was needed to supplement these requirements. See Letter from J. Dwight Hadley, Assistant Deputy Comptroller, Office of the N.Y. State Comptroller, to John Wheeler, Secretary, SEC, dated May 20, 1985.

See statement of Harold Boldt, Finance Director, City of Columbia, Missouri, at the Co~mission's Open Forum, May 21, 1985.

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Efforts are also underway to improve the operation of

book-entry record systems and to add more securities to these

systems, in recognition that the use of book-entry systems for

recording ownership of securities is an important means of

enabling parties to efficiently transfer.control of collateral.

In particular, the Federal National Mortgage Association

("Fannie Mae") and Freddie Mac have begun issuing certain

securities in book-entry form, and efforts are underway to

accelerate the conversion of certificated Fannie Mae and

Freddie Mac securities to the FRB book-entry system. In

addition, on March 25, 1985 the Mortgage Backed Securities

Clearing Corporation ("MBSCC"), operated by a subsidiary of

the Midwest Stock Exchange, Inc., began to offer depository

services in GNMA securities on a pilot basis to a small

number of firms. If successful, this or other programs could

replace the present physical delivery of GNMAs with a system

allowing delivery in a book-entry format.

Commission staff also has reviewed investment company

RP practices and reiterated to these funds the need to perfect

a security interest in RPs (i.e, the need to take possession

of collateral and to mark-to-market). The staff has written the

- 24 -. --r-o.

Investment Company Institute reiterating that, under· existing

Commissi'on interpretative positions, investment· companies must

obtain the securities underlying the RP transactions and, mark-

to-market, and asking that this position be recommunicated to

Institute members. 39/

The accounting profession' has also responded"t'o"the ESM and

BBS failures with a number of initiatives reviewi~'g' the need

'"

for modification or clarification of audit or accounting

standards regarding RP transactions by dealers and investors.

The American Institute of Certified Public Accountants'

("AICPA") Auditing Standards Board formed a special task

force to look into these auditing issues. This task force is

expected to produce a final report by June 30, 1985 indicating

that present auditing standards provide adequate guidance for

customers. engaged in RPs, but that additional educational

material discussing aUditing considerations should be added

to current specialized industry guides. The AICPA is also'

considering issuing a statement of position providing additional

guidance for disclosure of RP transactions"by"the thrift

industry. The Governmental Accounting Standards Board is

considering issuing a standard that would provide additional

guidance to municipalities regarding accounting for RP

transactions. Finally, the Commission's Chief Accountant's

39/ Letters from Division of Investment Management, SEC to Matthew Fink, General Counsel, Investment Company Institute, dated January 25, 1985, April 17, 1985, and June 19, 1985.

-25 -

Office and Division of Corporation Finance are preparing a

proposed release which would require greater disclosure of RP

activities and risks by registrants.

The FRBNY has responded to the problems' resulting from

ESM and BBS by increasing its informal oversight of primary

dealers, and by the adoption of voluntary capital adequacy

standards for dealers not otherwise sUbject to regulation. 40/ . . -

These standards are intended to provide investors with a

definable measure of firms' capital positions, to be used in

customers' determinations of which firms to deal with. FRB

supervised institutions are prohibited from dealing with

firms not providing certified statements of compliance with

these capital adequacy standards, and other investors are

encouraged to similarly restrict their dealings to firms

demonstrating compliance with these standards.

These responses by investors, dealers, and regulators

appear on the whole to have resulted in greater care being

tak'en in transactions in government securities, and in

particular, in RP transactions. At the same time, these

responses by their nature are uncoordinated and may sometimes

impose costs on RP investors which could cause them to decrease

their activity in, or cease trading in the markets. The principal

impact of this heightened caution appears to have fallen on

smaller secondary dealers, many of whom have experienced increased

40/ for Government Securi-

- 26 -

increased customer reluctance to engage in RP trades. 41/

Indeed, several primary dealers observed a trend among cus-

tomers of dealing only with primary or otherwise regulated

broker-dealers.!1/ In addition, the problems resulting from

BBS involving fails to deliver in GNMA RPs appears to have

caused a contraction in the GNMA RP market. Thus, some irid~stry

commentators, concerned about this market reaction, called

for a limited regulatory scheme for the government securities

market. Specifically, of the comments received on the Com­

mission's Release or at the Open Forum, 78% (18 of 23) of

primary dealer comments, 86% (19 of 22) of secondary dealer

comments, 83% (10 of 12) of investors and 63% (14 of 22) of

other commentators supported, further regulation.~cting

Assistant Secretary of the Treasury Niehenke and'other

commentators, however, expressed concern that additional

regulations could cause some legitimate dealers 'to withdraw

from the market. 43/

41/ Letter from Griffith X. Clarke, G.X. Clark,e& Co.,, to John Wheeler, Secretary, SEC, dated May 17, 1985~ letter from Ronald D. Upton, Executive Vice President, Irving T'rust, to John Wheeler, Secretary, SEC, dated May 17, 1985, at 6-7.

See discussion at note 17 supra.

See note 20 supra; see also letter from James W. Thompson Corporate Executive Vice President, NCNB National Bank, to John S.R. Shad, dated May 17, 1985.

- 27 -

II. Discussion

A. Joint Agency Regulatory Program

As discussed, the government securities market is by far

the largest securities market in the world and historically has

functioned remarkably free of serious difficulties without any

formal regulatory structure covering dealers in that market.

Furthermore, these markets are central to United States fiscal

and monetary policy, and additional regulations could increase

the cost to finance the national debt.

Commentators have noted that an insignificant increase in

federal interest costs would increase the annual deficit,

without eradicating'fraudulent activities, which the,SEC already

has the authority to expose and 'prosecute. However, it is

generally acknowledged that better market place disciplines and

regulation could deter and permit earlier detection of fraudulent

act'i vi ties.

The government securities market is more professional and ..

institutional than the corporate or municipal securities marke,t,

and any regulatory program for this market should reflect this

basic difference. Unlike the corporate and municipal securities

markets, custome'rs in the government' securities markets are

principally regulated ,entities. Therefore, in assessing what,

if any, additional regulation is needed for government securities

dealers, consideration must be given to regulations in place

for customers in the government securities markets. As discussed

above, there already has been a substantial "regulatory" response

by entities regulating customers in this market.

- 28 -

Accor~inglYQ if legislation is to be adopted, the Com-

mission would recommend only legislation drafted narrowly

to address areas in which there have been demonstrated abuses.

Specificallyv all bank and many non-bank dealers are already I 7.', ~

subject to a broad regulatory sc~emeo New regulation, if

determined to be necessary v should, wherever possible, neither

conflict with existing regulation, nor add new burdens on those

dealers.

The components of this legislative approach would be as

follows:

Registration. An initial step in all r~gulatory systems

is to ensure that the appropriate regulators have jurisdiction

over the relevant market participants. All currently unregis-

tered government securities brokers and dealers therefore

should be registered.!i/ The Commission believes that

44/, "Dealer" would be defined in a similar manner to secu­rities dealer (Section 3(a)(5) of the Securities Exchange Act of 1934 ("Act") and municipal securities dealer (Section 3(al(30) of the Act); "broker" si~ilarly would b~ defined (Sections 3(a)(4) and 3(a)(3l) of the Act). The Commission recognizes that significant interpretive advice will be .necessary in the early stages of the registration process to address the issue of who is a g'overnment securities dealer q and that exemptive relief may be appropriate for specialized groups. For example, it has 'been argued that mortgage bankers should be regarded as issuers of GNMAs so th.t regulation of them as deal~rs would be inappropriate. See letter from Glen S. Corson, Senior Staff Vice President, Mortgage Bankers Association of American, to John Wheeler, Secretary, SEC, dated June 3, 1985.

- 29 -

currently ~egistered b~oker-dealers who conduct their government

securitie~ business as part of the registered entity should.

retain their existing Commission registration. Similarly,

banks. that engage.in dealer .activities should not be required to

register separately. Th~SEC and Treasury differ as to which

should be the registrar for currently unregulated dealers.

Statutory Disqualifications. An integral part of the

regis·tration requirement must be the' authority to deregister

a government securities dealer and discipline its associated .'

persons. A consistent theme in. many of the recent government

securities dealers' failures has been that key personnel from

one firm move to other firms that subsequently run into

difficulty. ~hile.the Commission and the bank regulators

currently have the authority to prevent these nbad actors· from

moving ·f.rom. firm to firm within their respective industries,

cros~-over .from bank to non-bank dealers may require addit~onal.

administrative proceedi~~s. A system of "statutory disqualifica-

tio.ns" in the government secur~~ies market would ensure the

ability of each of the appropriate regulators to police the

movement of personnel in the industry. 45/ Accordingly, if . ,-

legislation is to be adopted, the Commission believes that the

bank regulators and the Commission should be granted authority

to provide sancti~nsagainst, or bar those, who violate either

the securities or the banking laws.

45/ See Sections 3(a)(39), 6(c)(2), and lSA(g)(2) of the Act.

- 30 -

Rulemaking. The Treasury and the FRS are charged with

the responsibility of administering the nation's fiscal and

monetary policies, and are the agencies in the best positiQn to

promulgate the most cost-effective rules to govern this market·.

Accordingly, if Congress concludes that additional legislation

is to be ~nacted, the FRS, Treasury and the SEC would find it

acceptable for the Treasury, in consultation with the FRS, to

be granted the authority to adopt rules as necessary on capital,

independent audit, and recordkeeping requirements.

Capital Adequacy Standards. With ,respect to the scope of

such rulemaking, one significant problem in the government

securities markets has been the lack of adequate ~apitalization

of d~aler~1 inde~d, the largest failures have involved dealers

that operated for s'ubstantialperiods of time while insolvent.

Concerns were also raised by commentators regarding the need

for limitations on the levels of risk and leverage taken on by

governmerit securities dealers. Accordingly, the Treasury, in

consultation with the FRS, would be empowered to adopt a capital

adequacy rule1 require financial reporting' by government securities

dealers to permit effectiv~ monitoring of their compliance with

this standard1 and require such reports to be independently

audited on a periodic basis. This independent audit should

specifically certify that the dealer is in compliance with the

capital adequacy requirements.

-31 ~

Registered broker-dealers that conduct a governmentsecu­

rities business would continue to be subject to the Commission's

net capital rule. Bank dealers would continue to be subject to

bank regulation of reserve requirements. Currently unregulated

dealers would be subject to the Treasury's rules, in consultation

with the FRB. The Commission and Treasury would work to

coordinate their respective rules.

Recordkeeping. If legislation is to be adopted, the

Treasury, in consultation with the FRB, should be given the

authority to adopt, as necess~ry, rules to assure maint~nance

of adequate records to verify compliance with applicable regula­

tions. Currently registered broker-dealers are, subject to

Commission rules l7a-3 and17a-4 under the Act concerning

books and records, while banks are subject the bank record­

keeping'requirements promulgated by bank regulators.

Co11atera1ization and Other Rules. The FRB, Treasury and

SEC also have concluded that if legislation is to be enacted,

they would find it acceptable for the Treasury, in consultation'

with the FRB, to adopt rules as necessary concerning co11ateral­

ization, margin and when-issued trading practices. Rules

relating to co11ateralization might involve matters such as

segregation of customer funds and securities or delivery require­

ments.

- 32 -

Inspection and enforcement. While no regulatory scheme ,"

can be expected to eradicate fraud, inspections may deter it

and permit earlier 'detection; While the commission J;>elieves

that the Treasury, in consultation with the FRB, should have

the primary rulemaking authorl.ty in the government securities

market, the Commission believes that the primary authority to

enforce such rules and inspect government ,securities' dealers

should reside' in current regulatory bodies, similar to the

regulatory system in the municipal sequrities market. Spe-

cif'ically, the body having primary regulatory jurisdiction

over 'a deaier would enforce the'rules and conduct. inspections.

Thus, the regulatory costs of the system are minimized because

existing regulatory agencies are used; 'such agencies'also are

used in the most cost-effective manner because in many 'instanc'es,

the oversight of,dealers' government securities business can

be combined with more general oversight "of. the securities

firms and banks. '

With respect to full~service broker-dealers currently

registered with' theCommissibn, ·the Commission, iri con junction

with the self-regulatory organizations ("SROS"),' already has

authority to inspect all business 'areas' of the registered

entity, including government securities activities. In

- 33 -'

addition~ the Commission and SROs would be given jurisdiction

to enforce the rules applicable to government securities

dea.1ers. Dealers that are currently unreg~lated also would

be subject to Commission and SRO inspection and enforcement. 46/

While the $ROs would have inspection and enforcement authority"

the full rul~s and reSl!lations of the SRO would be 'inapplicable

to a dealer that limits its activities to government securities.

With,respect. to bank dealers, the bank regulatory authorities

-- the FRB, the Office of the Comptroller of the Currency and

the FDIC -- would have authority over those dealers within

their respective jurisdictions.

B. Commission Proposal

While the Commission has not conducted a formal cost-

benefit analysis, if legislation is to be enacted, the Commission

recommends the joint approach described above that the Commission,

FRa ~nd Treasury find acceptable, with two modifications. First

46/ A newly-registered government securities dealer would be required to join the SRO, or SROs, such as the NASD or stock exchanges, that is most appropriate for its mix of business. For example, a government-only subsidiary' of a New York Stock Exchange ("NYSE") member firm may elect to join the NYSE. Regulatory responsibility for a dealer would be allocated to the appropriate SRO. See Rule l7d-2 under the, Act.

- 34 -

because the Commission is the federal agency responsible for

registering all broker-dealers the Commission believes that it

would be preferable for it to register sole government securities

dealers. Because the Commission and the SROs will have inspection

and enforcement authority over previousl~unregistered dealers,

. registration with the Commission also would provide more

efficient monitoring of these dealers and their associated persons.

Second, with respect to scope of Treasury rulemaking, in

consultation with the FRB, the Commission concurs that such

authority should encompass capital, independent audit and

re,cordkeeping requirements. With respect to rulemaking' authority

on collateralization, margin and when-issued trading practices,

while the Commissio.n would find such rulemaking acceptable, it

believes the combination of present anti-fraud authority under

the federal securities laws and the other new inspection and

rulemaking authority outlined in the model described above, are

sufficient to address the problems underlying the recent failures

of government securities dealers. In addition, the state and

f~deral regulators of the institutional investors in government

securities have addressed, or are addressing, collateralization

and related issues. Therefore, the Commission's preferred

approach would be not to include suchrulemaking authority in

the current legislative package.

- 35 ~ .

c. Other Regulatory Proposals

The Commission recognizes that other regulatory initiatives

have been proposed and believes that two of those proposals

warrant specific discussion. Those initiatives are the proposals

(i) that customers take possession of securities underlying RPs

in all instances; and (ii) that there be a SRO to govern the

government securities market.

with respect to RPs, a significant amount of the customer

losses in both ESM and BBS resulted from the failure of

c,ertain customers to require their dealers to deliver the

government securities underlying RPs. In response to these

losses, and because taking delivery of securities is generally

viewed as good business practice, there has beer:tsignificant. . .

discussion about requiring customers to take possession of

underlying securities in all RPs. Indeed, one legislative

proposal would generally require government securities dealers

to deliver the securities underlying RPs to the investor, or

permit the investor to perfect a security interest in the

securities through a third party RP. 47/ The commission

appreciates the reasons underlying these discussions and

Proposed "Government Securities Market Protection Act", H.R., 2521. In a third party RP the custodian bank acts as agent, both for the dealer and the cus­tomer; the customer thus ·can be viewed as being in possessio~ of the securities.

- 36 -

proposals. The Commission is not prepared, however, to support

a requirement that customers take possession of collateral in

all instances.

While the Commission believes that physical possession of

securities underlying RPs is desirable and should be encouraged,

more cost-effective alternatives are often available. In the

great majority of government securities financing activities,

there are legitimate situations in which alternatives to physical

delivery may be appropriate. For example, primary dealers

"hold-in custody" arrangements provide for segregation of

customers' securities. 48/ Also, physical delivery of short'

term RPs and RPs in certificated securities ",:ould be prohibitively

expensive. In recognition of this fact, 17 of the 22 government

securities dealers commenting on this issue in response to

the Commission's release opposed any statutory requirement of

perfecting a security interest through possession or otherWise.

With respect to the costs of delivery, the commission

understands that bank charges to customers for either delivery

48/ Hold-in-custody arrangements for government securities RPs are functionally the same as custody arrangements for customer funds and securities under Commission Rule lSc3-3 under the Act. Registered broker-dealers. that deal in government securities generally use such custody accounts to immobilize government securities positions. To require physical delivery of all non-wireable securities, therefore, may actually impede Commission efforts to facilitate the immobilization of securities.

- 37 -

or receipt of securities subject to repurchase over the FRB

wire range from $15 to $50 for each end of the RP (including

both wire charges and bank handling charges). For certificated

securities, the charges can be significantly higher -- cost

estimates range from $30 to $60 per security delivery and

redelivery, with the possibility that a single RP may involve

delivery of a number of securities. 49/ These costs are

sufficient, in the view of commentators, to render economically

infeasible any short-term RP for less than a million dollars,

and an even greater variety of RPs involving certificated

securities. 50/

49/ Delivery also requires a customer to establish a separate bank custodial account, estimated to cost approximately $300 a month.

50/ 'l'he Commission has attempted to quantify the costs of requiring delivery in a short-term RP. The Commission has used a nominal 8% RP with total transaction costs of $120 ($30 per receipt and delivery for each of the two parties). The Commission further assumes that the purchaser pays all costs in an RP and the seller pays the costs in an RRP. Under -such circumstances, the effective annual yield to be received by a purchaser (after transaction costs) is only 3.68% for an overnight RRP of $1 million. This rate would increase to 7.38% for a one week RRP, 7.86% for a one month RRP and 7.93~ for a 60 day RRP. Conversely, in a RP of the same size and rate, the seller would pay 12.32% for an overnight RP (after transaction costs), which would decrease to 8.62% for a one RP, 8.17% for a one month RP and 8.07% for a 60 day RP.

- 38 -

In addition to being costly, an across-the-board delivery

requirement would impose operational qurdens on the industry.

With respect to book-entry Treasury and agency securities,

there already are significant delays on the FRS wire system,

and its use for additional RP deliveries c6uld inciease delays.

The FRS has estimated that expanding the system to facilitate

delivery of securities in all RPs would entail a one-time cost

of $10 - $20 million with ongoing costs of $25 $lOOmillion

a year.

Even more serious problems would be raised by a delivery

requirement for certificated securities, particularly GNMAs.

GNMA deliveries are time consuming and complex, and, in the

view of many commentators, the unavailability of hold-in­

custody arrangements would restrict the availability of

GNMAs and other similar instruments for RPs and impair the

operational integrity of the GNMA market. This, in turn,

would make it more difficult for dealers to finance GNMA

positions and would likely impact adversely spreads and

yields in the GN~~ market.

- 39 -

For these reasons, the Commission does not recommend

legislation mandating delivery of securities subject to

repurchase.

With respect to the proposal of an SRO for the government

securities markets, the Commission recognizes that there have

been a number of proposals, including proposed legislation, 51/

that would vest rulemaking authority for the government securi­

ties market in a new SRO or in an existing SRO, such as an

expanded Municipal Securities Rulemaking Board ("MSRB") which

would be renamed the Public Securities Rulemaking Board ("PSRB").

The Commission would not recommend such an SRO rulemaking body

for the government securities market.

First, with respect to ~xpanding the jurisdiction of't~e

MSRB, as noted by a number of commentators, the government and

municipal securities markets are significantly different and

it would be difficult to constitute a single board with

sufficient expertise in both areas to respond to the unique

aspects of each market. The MSRBrepresents well the various

aspects of the municipal securities industry, including

representatives of municipal issuers and sole municipal

securities dealers. Commentators suggest, however, that these

board members would not necessarily be appropriate members of a

board overseeing the government securities industry.

~l/ Proposed "Public Securities Act of 1985," H.R. 2032.

- 40 -

In a dual ~arket board, the need for such representation of

the municipal securities market would have to be balanced

against sufficient representation for all aspects of the

government securities markets, such as primary dealers (in­

cluding banks, full service broker-dealers and sole government

dealers) and the wide range of secondary dealers and investors.

Second, the Commission does not believe that a separate SRO

for the government securities market should be established.

As discussed, the Commission believes that any rulemaking in

the government securities market should be relatively narrow

in scope. Beyond promulgating an initial set of regulations,

commentators questioned whether there would be sufficient

need for continuing SRO involvement in the rulemaking process

to justify the ongoing expenses of a PSRB. Rather, the Treasury"

with the consultation of the FRB, will be in the best position

to "fine-tun~" the regulatory system as the need arises, en­

tailing little additional expenses.

Finally, the Commission believes that it would not be

appropriate to expand the jurisdiction of either the stock

exchanges or the National Association of Securities Dealers,

Inc o ("NASO") to cover government securities rulemaking.

These SROs have historically limited their rulemaking activities

to corporate securities and the Commission believes that it

would be an unjustified expense to require them to develop

- 41 -

expertise in the government securities market. In this regard,

it is not contemplated that increased rulemaking responsibilities

would impose significant resource burdens on the Treasury.

V. Conclusion

The Commission has been impressed by the marketplace's

prompt reaction to the recent government securities failures.

Market participants have a "pocketbook" interest in minimizing

their risks on a cost-effective basis.

While the FRB, Treasury and SEC differ sOloewhat in their

views of the necessity for legislation, if Congress concludes

that additional legislation is to be enacted, they would find

acceptable the approach set forth in Sections II and III of

the Executive Summary above.

While the Commission has not conducted a formal cost­

benefit analysis, if legislation is to be enacted the Commission

recommends the approach set forth in Section IV of the Executive

Summary above.

The Commission thanks the subcommittee for this opportunity

to present its views on the important issues raised in this

area. The Commission would be pleased to offer whatever

assistance the subcommittee requests in drafting legislation

it believes t? be appropriate.

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Exhibit 1

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-21959~ File No. S7-l7-85]

Request for Comments on the Oversight of the U.S. Government and Agency Securities Markets

AGENCY: Securities and Exchange Commission.

ACTION: Request for Comments.

SUMMARY: The Commission is seeking comments on the U.S.

government and agency securities markets and dealers, in

order to determine, in consultation with the Treasury and

the Federal Reserve Board, whether legislative or regulatory

initiatives are necessary to address the problems posed by

recent failures of government securities dealers~ and if so,

the most practical, cost-efiective form of such rul~s and

regulations.

DATES: Please respond not later than May 20, 1985. Your

prompt response is appreciated. The Commission intends

to hold a public meeting on May 23, 1985 where respresenta-

tives of the government securities markets will have an

opportunity to discuss the issues posed in this release.

ADDRESS: Please file five copies of your comments with John

Wheeler, Secretary, Securities and Exchange Commission., 450

Fifth Street, N.W., Washington, D.C. 20549. Refer to File

No. S7-17-85. All comments will be available for review at

the Commi~sion's Public Reference Room.

FOR FURTHER INFORMATION CONTACT: Andrew E. Feldman, (202)

272-2388, Division of Market Regulation, Securities and

Exchange Commission, 450 Fifth Street, N.W., Washington, D.C.

20549.

',.' , .;

- 2 -

SUPPLEMENTARY INFORMATION:

Executive Summary C5 pages):

The Problem: Over the past seven years, the widely publicized

failures of several small government securities dealers, in­

cluding within the past month E.S.M. Government Securities,

Inc. C"ESM") and Bevill Bresler & Schulman Asset Management

Corp. CWBBS"), have had repercussions throughout the financial

markets.

The SEC estimates that over $500 million of losses have

been sustained by the firms and institutions, that dealt with

ESM and BBS. Such losses have been attributed principally to:

fraudulent concealment of ESM's and BBS's financial conditions;

their use of the same collateral for multiple transactions; and

in the case of ESM, over $200 million of its $300 million of

losses have been attributed to transactions with thrift institu­

tions which the receiver has alleged were under the control of

the same individual. Additional losses were sustained by in­

dividuals, including taxpayers and employees of municipalities

and the customers of 71 Ohio thrift institutions who lost

access to their funds.

The Market: The annual dollar volume of trading in U.S.

government and agency obligations is over 15 times that of

all U.S. securities exchanges and over-the-counter markets.

It is by far the world's largest and most efficient securities

- 3 -

market. It is of pa~amount importance to the effective, low­

cost financing of the national debt as well as administration

of the nation'. fiscal and monetary policies. In addition,

the government securities markets are important to the other

nations that use o.s. dollars and government securities for

their reserves and as a medium of international exchange~ as

well as to commercial enterprise throughout the free world.

The Regulatory Structure: There are 36 primary government

securities dealers that report to the Federal Reserve Board

("FRB") on a daily, monthly, and annual basis~ and an unknown

number of secondary dealers, whose government securities trans­

action.s are largely unregulated al though 27 report to the FRB

on a monthly basis. These firms primarily deal with institu­

tions as opposed, to. individuals, al though these insti tutions

have varying degrees of sophistication. Representatives of

the FRB have indicated that it intends to adopt voluntary

capital adequacy guidelines for dealers not otherwi~e subject

to federal regulation.

Neither the FRB nor the SEC has specific statutory authority

over those firms that deal exclusively in government securities.

Nevertheless, the vast majority of secondary market government

securities transactions are handled by primary dealers subject

to monitoring by the FRB: banks subject to the jurisdiction

of the FRB, the Comptroller of the Currency and/or the FDIC: or

- 4 -

registered broker-dealers subject to inspection and re9ulation

by the SEC and self-regulatory organizations. The SEC also

has the authority to sanction these firms and anyone else

that engages in fraudulent securities activities.

The Question: Can losses in the government securities market be

inhibited, reduced or prevented in the future? How can that be

done on a cost-effective basis? The rationale and factual basis

for your response to those questions of which you have special

knowledge or experience is requested. Some of the key questions

are summarized below.

How widespread are these problems? Are the underlying

practices of double collateralization and demanding excess

margin common among government securities dealers? If so,

is there a significant risk of other government securities

dealers failing?

What is the reaction in the marketplace to the widely

publicized ESM and BBS failures? Are those who deal in the

government securities market now properly perfecting their

collateral? Are they shifting from small to large dealer?

- 5 -

Are there likely to be more failures as a result of investor

reactions to the ESM and BBS failu~es?

If greater regulation is necessary, which of the following

alternatives would be the most cost-effective? Which would

maximize investor protection and reduce or elim~nate mistakes

and deceptions at the least cost?

Should dealers be required to deliver through the FRB's

or other book-entry systems, government securities that are

transferred, or pledged under repurchase agreements?

Should the FRB's proposed voluntary capital-adequacy guide­

lines for government dealers be made mandatory? Should those

guidelines be expanded to include voluntary registration and

segregation of customer positions subject to audit and inspec­

tion by theFRB?

Should there be direct regulation of government securi­

ties dealers by the FRB or the SEC? Or should a self-regulatory

organization be created under the aegis of the SEC -- or'the

FRB? Or should the authority of the Municipal securities

Rulemaking Board, under the SEC's oversight, be expanded to

include government securities markets and dealers? What

responsibilities and authority should the SRO have? In

particular, should the SRO's authority be limited to

imposing financial and operational requirements or should

- 6 -

it also be authorized to regulate the business practices of

government securities dealers?

As a result of the losses incurred in ESM and BBS, Congres-

sional committees have requested the Commission's recommenda-

tions of cost-effective means to reduce, inhibit, or prevent

such losses in the future. The Commission is, therefore,

seeking comment on the current functioning of the market for

government securities and possible regulatory and other

initiatives. In view of the broad range of the questions,

commentators are not expected to respond to all of them, but

factual responses and estimates within commentators' areas of

expertise or experience are respectfully requested.

I. Introduction

A. The Governments and Government-Related ("Agency") securities .Markets

The market in u.s. government and agency securities is by

far the largest and most efficient securities market in the

world. The monthly trading volume of just the 36 primary

government dealers that report to the FRB amounts to over $1.5

trillion -ll - or approximately 15 times the total volume of all

-ll Office of the Secretary, Department of the Treasury, Treasury Bulletin, 1st Quarter, Fiscal 1985, Table FD-2, at 15 ("Treasury Bulletin"). Of this debt, $1.247 trillion was in marketable Treasury securi­ties. ·Government agency debt (~, Government

(footnote continued)

- 7 -

trans~ctions in corporate securities traded on all the nation's

securi~ies exchanges and over-the-counter markets. ~/ In the

government market, the "spread" between bid and asked prices

and the brokerage commissions are a fraction of those in

other securities m~rkets.

Individuals hold nine percent of u.s. government obliga-

ations. Much of the remainder is held by a wide variety

of institutions including municipalities, corporations,

(footnote continued)

~/

National Mortgage Association ("GNMA") securities) outstanding totalled $35 billion and government­sponsored agency debt (~, Studen Loan Marketing Association ("SLMA"J Securlties) outstanding totalled $224.3 billion in October 1984. Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, ,March 1985, Table 1.44, at A-33.. ("Federal Reserve Bulletin").

In 1984, dealers reporting to the Federal Reserve Bank of New York ("FRBNY") reported transaction volume averaging $52.7 billion daily in Treasury securities and $7.8 billion daily in agency secu­rities. Federal Reserve Bulletin, supra note 1, Table 1.42, at A~3l. In contrast, the daily dollar volume of trad~ng in 1984 on all United States stock exchanges and the NASDAQ over-the-counter market . averaged only $4.5 billion. Based on SEC Statistical Review, February 1985, Table M-llO, and NASD 1984 Annual Report. These figures are used for illustrative purposesonly~ .they cannot be directly compared because of differences .in the way dollar volume is calculated in these markets.

- 8 -

and pensi~ns.funds •. 2;: Most of the dealers that participate

in the original issue and resale of these securities to in­

stitutional investors maintain active ongoing secondary markets

for these securities.

In the Treasury securities.market a system of ·primary··

and ·secondary· dealers exists. ·Primary dealers· are

those dealers with whom the FRBNY is willing to deal directly

in conducting its open market operations to implement the

FRB's monetary policy. The FRBNY regards the primary dealers

as the principal market makers in the secondary market. At

present there are 36 primary dealers in Treasury securities,

of which 13 are banks, 12 are broker-dealers registered with

the Commission, and 11 are unregistered dealers.

Primary dealers are expected to bid for a substantial share

of Treasury securities in Treasury auctions -il and make continuous

21 See Treasury Bulletin, supra not~ 1, Table OFS-l~ 2, ~3l. In December 1984, private investors held 72% of the outstanding Treasury securities, includin9 8.7% held by individuals. The remaining share of this debt was held by United States Government accounts and Federal Reserve Banks. Id.

The Treasury Department, through the Federal Reserve Banks, sells marketable Treasury securities to the public through an auction process. These securities are bought directly at auction primarily by dealers but also by investors. Report of the Joint Treasury-SEC~ "_ Federal Reserve Stud of the Government-Related Securities Mar ets December 1980 at 37 ·Government-Related Securi~. ties Report").

- 9 -

markets in these securities. In addition, they are required to

submit daily, monthly, an~ annual reports to the FRBNY showing '" .

their transactions, positions, and capital: the FRBNY monitors

the activity and financial soundness of these primary dealers

through these reports and by frequent contacts through telephone

calls and on-site visits.

In addition to these primary dealers, there ate a

larger number of secondary dealers that trade Treasury

securities but do not deal directly with FRBNY. The number

of these secondary dealers is unknown although officials of

the FRB have estimated there may be 200 or more government

securities dealers. ~/ The FRBNY has encouraged secondary

dealers to report on a month1ybasis information similar

to that provided by primary dealers. As of April 1985, 27

non-bank secondary dealers ~/ were voluntarily reporting this

~/ The Commission specifically requests commentators to provide estimates of the number of secondary dealers active in ,these markets at present: their aggregate positions: and the annual dollar transaction volume of their transactions.

-!/ The agency securities market is not differentiated into primary and secondary dealers. While many of the dealers in Treasury securities also make markets in agen~y securities, the precise number of dealers in thi~ market also is unknown. Information con­cerning the size, nature, and number of dealers in this market would be appreciated.

- 10 -

information. -21 In addition to directly monitoring primary

dealers and encouraging secondary dealers to report volun-

tarily, the FRBNY has indicated that it intends to adopt

shortly voluntary capital adequacy guidelines for Treasury

securities dealers not otherwise subject to federal regulation. ~I

These oversight activities depend largely on voluntary

compliance and moral suasion, and, for the primary dealers,

the ultimate threat of the FRBNY ending a firm's primary

dealer status. The FRBNY has no statutory investigation or

-21

..,!I

Comment is requested on the efficacy of these reporting requirements. In this regard, it should b~ noted that ESM was a reporting dealer •

FRBNY, Ca ital Ade uac Guidelines for u.s Government Securities Dealera, Re uest for Comments February 7,

9 These gu e lnes wou d requlre that a dealer in Treasury securities keep the size of its risk consistent with the amount of liquid capital available to absorb losses. While compliance would be voluntary, the FRBNY would require primary dealers, and str"onglY encourage other dealers, clearing and lending banks, and customers to deal only with firms who have been certified by their auditors as complying with these guidelines. The .FRBNY also would encourage other bank supervisors to look for certification letters in examining bank clearing and lending activities for Treasury securities accounts.

- 11 -

enforcement authority over these dealers. However, 25 of the

~6 ~iimary dealers~ and approximately half of the 27 secondary

dealers voluntarily repo~ting to the FRBNY, are regulated by

one or more bank regulatory agencies or the SEC.

The Commission similarly has no direct statutory authority

over the government securities markets. Government securities

are exempt from the registration provisions of the federal

securities laws, -2/ although transactions in such secu-

rities are subject to the anti-fraud provisions of these .~ . ,.

laws. 10/ Broker-dealers who effect transactions exclusively

in government securities are exempt from the broker-dealer

registration provisions of the securities laws. However,

those that also effect transactions in corporate or municipal

~/

Sections 3(a)(2) of the Securities Act of 1933 (the wSecurities Act W ) and 3(a)(12) of the Securities Ex­change Act of 1934 (the wExchange Act W

) define govern­ment securities as exempt for purposes of the regis­tration and periodic reporting provisions of these Acts.

Sections 17(a)of the Securities Act and 10(b) of the Exchange Act, and Rule 10b-5 thereunder, apply to the offer, purchase, or sale of any securities. As a result, these sections apply to government securities. While the Commission lacks statutory authority to examine regularly sole government securities dealers,

. it may conduct investigations to determine whether thes~' firms have violated the anti-fraud provisions.

- 12 -

securitie~ must register with the Commission. 11/ The govern­

ment securities activities of registered broker-dealers are

subject to Commission financial responsibility, recordkeeping,

reporting, and other regulations.

In addition to the informal oversight activities of the

FRBNY for primary dealers in the government securities area,

all activities of banks, including their government securities·

activities and investment practices, are subject to the direct

regulatory oversight of the appropriate regulatory authority

for the bank (the FRB, the Comptroller of the Currency, or the

Federal Deposit Insurance Corporation). Moreover, the invest-

ment activities of many institutional entities in the government

securities market are subject to review by regulatory bodies

that supervise them. For instance, the FHtBB provides regula-

tory oversight over savi~gs and loan associations and other

thrift institutions, the National Credit Union Association

(-NCUAW) over credit unions, the Department of Labor over

pension funds, and state insurance commissions over insurance

companies. 12/

11/ Section 15(a)(1) of the Exchange Act. In addition, exclusive government securities broker-dealers are not required to become members of a self-regulatory organization (WSROW) under the Commission's oversight.

For an account of this oversight for government securities, see generally Government-Related Securities Report, supra note 4, at 176-204.

-13 -

Overall,. the government securities markets function

efficiently under the present reguiatory framework. 13/ A

number of developments in recent years, however, have

placed increased pressure on these markets. The most

significant of these developments is the increasing amount

of government debt required to be financed each year. In

addition, the volatility of interest rates at times in

recent years has greatly increased the market risks of

taking positions in government securities. 14/ These risks . . ---

are exacerbated by virtue of the complexity and high degree

13/ See,~, Statement of E. Gerald Corrigan, President, FRBNY, before the Subcommittee on Domestic Monetary

, Policy of the House Committee on Banking, Finance and Urban Affairs (April I, 1985), at 12 ("the market as a whole continues to function.effective1y in fair weather-or foul").

The development of a variety of financial futures and options, such as futures on Treasury bonds, has enabl~d market participants to hedge against these increased derivative risks. At the same time, these instruments also can be used themselves to assume highly leveraged unhedged positions that can carry substantial risks.

- 14 -

of leverage possible in the government securities markets

through the use of repurchase agreements. 15/

Moreover, despite the importance of the government

securities markets for the nation's financial system, entry

into these markets as a dealer, with its potential impact

on other participants, is relatively simple. In the absence.

of dealer registration and capital requirements, it is

possible to go into business as a government securities

dealer with a minimum of capital or experience. 16/ However,

the interconnected nature of the market may cause the misfeasance

or failure of even a small firm to have repercussions dispropor-

tionate -to its size. Furthermore, the nature of the investors

in the market may cause any such failure to have widespread

consequences throughout the financial system.

15/ The term -repurchase agreement- refers to an agreement to sell securities subject to a commitment to repurchase from the same person securities of the same quantity, issuer, and maturity~ See Rule lSc3-l(c)(2)(iv)(F)(9) under the Exchange Act.

Illustrative of the ease of entry into the government securities markets is the case of Eldon Miller. After operating Miller Truck and Sales Service in Iowa, in the early 1970's Miller renamed his company Financial Corporation and in January 1974 opened an office on Wall Street. Starting with $400,000 in capital, by July 1975 Financial Corporation held $1.9 billion in assets, but approximately $18 million more than that in liabilities. The court declined to issue an injunc­tion against Miller although it found that Miller had violated Rule 10b-S under the Exchange Act. SEC v. Miller, 495 F. Supp. 465 (S.D.N.Y. 1980).

- 15 -

B. Problem Incidents in the Government Securities'Markets

Over the past seven years, there have been a number

of highly publicized failures or near-failures involving

unregistered government securities dealers, most of which

have been affiliates of registered broker-dealers. These .

include Winters Government Securities (1977), Hibbard &

O'Connor Government Securities (1979), Drysdale Government

Securities (19~2), Lombard-Wall (1982), Lion Capital (1984),

and most re~ently ESM and BBS (1985). These incidents have

involved market participants that have engaged in highly

speculative, and in some instances, fraudulent trading activi-

ties in government se~urities. The failure or near failure of

these firms has resulted in losses totaling hundreds of millions

of dollars with broad,. and even international, 17/ repercus­

sions. These failures underscore the dangers of problem,

incidents to other participants in these markets and to public

confidence in these markets generally.

The two recentfailures'cf ESM and BBS exemplify the problems

that have arisen and theii potential effects. The failure of

ESM in March 1985 allegedly resulted in losses to investors

involved in repurchase and ,reverse repurchase transactions

17/ Foreign Currencies Gain on Troubles at Bevill Bresler, Wall Street Journal, April 9, 1985, at 50.

- 16 -

with ESM of over $300 million. 18/ It also resulted in the

failure of a privately insured Ohio savings bank. ESM, an

unregistered government secu,ities dealer, allegedly failed

for over five years to reflect in its financial statements

the fact that it had incurred substantial losses from trading

reverses and high expenses incurred by the firm. ESM allegedly

was able to continue operating despite these losses because

of its inaccurate financial statements~ transactions with two

thrift institutions, which the receiver has alleged to be

under the control of the same individual, that essentially

funded a large portion of ESM operations~ and because ESM

customers were no~ adequately collateralized in their transac-

tions. 19/

The April 1985 bankruptcy of BBS, an unregistered government

securities dealer, may result in losses to customers, mostly

savings and loan associations and banks that had engaged in repur­

chase and reverse repurchase transactions with BBS, of as much as

18/ These are estimated losses without consideration of tax consequences, insurance, and civil suit recoveries, if any.

Tew, Rece ver, SEC v. ESM as=61-90-Civ-Go-n-z-a~1-e-z-,~I~n~~~~~~~~ (S.D.Fla.) April 2, 1985.

·- 17 -

$233 million. 20/ BBS allegedly provided·financing for a related • government securities dealer which has incurred large trading

, r:"·· ,:,.'.,

losses. BBS allegedly also engaged in loans with an affii~ate,

a registered broker-dealer. BBS allegedly was able to continu~

operating, in part, because customers were not adequately col-.': ... ~:.~ .... ~~

lateralized. Apparently as a direct result of BSS's failure, , .,!~',':~'"

Bevill, Bresler & Schulman, a·registered bioker-deale~~ifiliate

of BBSi Brokers' Capital (and an affiliated futures commission

merchant); and Collins Securities, Inc., another registered

broker-dealer, ei ther have been enjoined from or voluntar.ily have

ceased doing business~ Losses with respect to Brokers' Cap~~al

anp Collins Securities, Inc. have been estimated to be less than .~.,

$5 million.

II. Discussion

The failures of ESM and BBS, coming after the series of other

incidents involving small, unregulated government securities

dealers, have raised concerns about the possible adverse effects

of these incidents on confidence in the government securities

markets. The failures have also raised qu~stio.ns .... about whether

there is a need for corrective action with respect to partici-

pants in these markets. At hearings on March 21, 1985 before the

~/ These are estimated losses without consideration of· tax consequences, insurance and, civil suit rec9,veries, if any.

- 18 -

Teleeommunications, Consumer Protection and Finance Subcommittee . .

of the.House Energy and Commerce Committee, the Commission in-

dicated it would consult with the FRB and the Treasury and

adyise Congress within 90 days on whether additional regulation

is needed and if so the most cost-effective approaches.

In responding to the specific matters discussed below, the

Commission requests that commentators bear in mind the following

three general considerations. First, because of the importance

of the government securities markets to the monetary and fiscal

polic~es of the nation, it. is crucial to ensure their continued

efficient operation. Maintainin~ or, if possible, improving

the efficiency of these markets is of paramount importance.

Accordingly, the Commission requests that commentators, in

responding ~o the specific questions raised by the Commission,

attempt to. address the effects of possible regulatory actions

on the ability of the Treasury and FRB to fund the public debt

and execute the nation's monetary policy in the most efficient

and least costly manner possible. In particular, commentators

are asked.to provide information about the costs and benefits of

increased regulation to the Treasury Department and other entities

issuing government secu~ities.

Second, any evaluation of regulatory alternatives for the

government securities markets must carefully consider the costs

of that regulation as well as the potential benefits to investor

protection, market efficiency, and investors' confidence that

additional regulation might provide. While such a cost-benefit

- 19 -

analysis is an important elemerit in any regulatory initiative,

it is particularly critical in the government securities

markets because of size and importance of these markets.

For example, one cost of government securities dealers failures

could be the withdrawal from the market of a substantial number

of investors. On the other hand, such failures could induce

a -flight to quality- in which investors deal only with more

established firms. Thus, in evaluating the specific issues

. discussed below, commentators are requested to identify and

quantify to the extent possible the costs and bene£its of

taking further regulatory action, as well as declining to take

further action.

Third, the regulation by the Commission and the SROs of

non-exempt securities broker-dealers generally has operated

effectively~ While no system is fool-proof and there have

been some' major failures of regulated broker-dealers, the

Commission believes that the regulatory system for registered

broker-dealers promotes investor protection. It deters fraud

and permits earlier detection of fraudulent activities.

Nevertheless, there are a number of differences in the customers

and activities of government securities dealers and broker­

dealers presently regulated by the Commission. Broker-dealers

currently 'registered with the Commission generally deal directly

with individual investors as well as institutions: whereas

government securities dealers deal primarily with other dealers

and corporate, municipal, and institutional investors.

- 20 -

In responding to the specif.ic questions raised below, the . ,'. ":-:'"

, " ~

Commission requests comment on the relevant similarities and

differences between the activities of government securities

dealers and registered broker-dealers •. 2l( In this regard, .. ;~~ , .-

as the BBS case illustrates, activity in .. th.~ government secu-. :· •• ·f?,;> •. ··

.rities markets can have repercussions for related registered

broker-dealers and their customers. Hence, commentators also

are requested to discuss the impact on the corporate and municipal

or other securities markets of taking regulatory action, and·

declining to take such action, in the government securities

area.

The Commission has divided its specific questions into

two general categories:. (1) issues relating to the costs and

benefits of further federal regulation of government securities

dealers and the structure that any such regulation should take~

and (2) if further regulation of government securities dealers

is considered necessary, the specific areas that should be

The Commission also requests specific comment on which market participants should be considered as dealers in government securities, and how this universe should be defined. The Exchange Act's definitions of -dealer- (Section 3(a)(5» and -municipal securities dealer- (Section 3(a)(30» turn on whether a person buys and sells securities as part of a regular business. This language has been interpreted to ~istinguish between professional investors and market makers. Commentators should consider whether this type of distinction is feasible in a market where large positions may be taken for cash management purposes as well as to generate trading profits.

- 21 -

regulated. In addition, the Commission invites commentators

to address any other issues they believe to be important.

A. Costs and Benefits of Regulatory.Alternatiies ~ • • - 1'- ~ .', •

Possible respon~es to recent problems-range from workin~

within the present regulatory framework to creating an SRO

for government securities dealers, perhaps coupled with

registration with, and regulation by, one or more federal

agencies.

1. Responses by the Private Sector and Regulators _ of Investors

One approach would be to rely primarily on re~ponses by th.

private sector, and possibly regulators of institutions that in­

vest in that market, to meet the problems raised by the recent

failures. In that connection, how effectively is the marketplace

responding to the widely publicized problems of ESM and BBS?

Please describe steps that are being taken. Abuses involving .. '. I,'

GNMA standby contracts in the late 1970tSdfssi~~ted when the

less sophisticated institutional investors who had engaged in

transactions in standbys substantially reduced their participa-

tion in that market. In addition, the NCUA, FHLBB, and bank

regulatory agencies each adopted guidelines or rules Jnterided . ~ - .....

to limit the activities of regulated institutions in standbys

and forwards. ~/ Similarly, the losses incurred in the Drysdale

failure were largely the result of a failure by investors to

22/

.. .... ~

See Government-Related Securities Report, supra note 4, at 176-204.

- 22 -

account for accrued interest on securities loaned to Drysdale,

a shortcomin9 that has since been corrected by standard in-

dustry practices. 23/

In both ESM and BBS, it appears that investors incurred sub-

stantial losses because they were not properly collateralized.

This apparently occurred because investors failed to take all

the measures necessary to assure adequate possession or control

of their collateral. This also was alleged to have resulted from

fraud and deception on the part of the 90vernment securities

dealers (and perhap~ their registered broker-dealer affiliates)

involved in these failures. With respect to ESM, substantial

losses also were incurred by two institutions, apparently

controlled by the same individual, which provided ESM with

excessive margin. The Commission requests comment on the

private sector's response to these failures. What steps have

dealers, includin9 secondary dealers, taken to respond to

these failures? In addition, are investors that do business

with government securities dealers takin9 actions to ensure

that their transactions are properly collateralized? Are

they more actively auditing their collateral when it is held

in custody by a 90vernment'securities dealers? If so, how

could such an auditin9 task efficiently be carried out?

Have the recent failures resulted in a "flight to quality"

~, ~, Public Securities Association, Business Practice Guidelines For Partici ants in the Re 0 Market October 982.

- 23 -

with investors transferring their repurchase activities to

larger, better known dealers.

Commentators who believe there has been or will be signifi­

cant private sector response to ESM and BBS are requested to

discuss whether this response reduces the risk of future frauds

of a similar magnitude. At the same time, commentators are also

requested to address whether one cost of a solely private response

to government securities dealer failures is the withdrawal from

the market of a'substantial number of investors. and whether any

such wi thdrawal':may advers.ely affect the government securi ties

markets on a short and long term basis •

. 2. Collateralization

An al~ernative approach would be legislation or additional

regulation requiring government securities dealers or customers

to take steps to ensure that such transactions, including re­

purchase agreements, are properly collateralized, possibly

through electronic book-entry systems. This approach would

reduce· the risk of a.dealer using the same collateral to secure

more than one transaction. The Commission requests comment

on the feasibility of and the expen~es associated with such

collaterization of both long and short term transactions.

Those who incurred losses in ESM and BBS apparently were pri­

marily, if not entirely, dealing in long term transactions.

The Commission understands that the charge to an institu­

tional investors of a Treasury securities movement over the Fed

wire is approximately $38. In this connection, the Commission

- 24 -

requests comment on the costs to investors of transfer of a

Treasury securities position, and the receipt, custody, and ... , ... ' ,

examination of a position in a safekeeping account for the t,,: .••. "

benefit of customers.

The Commission also requests comments on the costs of

collateralizing GNMA securities which are presently not

included in a book-entry system. Some government securities

dealers have indicated that the cost to transfer GNMA securi-

ties could be as high as $20 per pool, and noted that the

delivery of a round lot (one million dollars) of GNMA securi­

ties may involve up to three pools. The Commission also

requests comments on any operational problems in collaterizing

GNMA transactions. 24/

In add~essin9 the costs entailed in a collateraliza~ion

requirement, commentators should distinguish between, the costs

for overnight and term repurchase, .. agreements~· 'In this connec-

tion, the Commission notes that the collateralization abuses

occurring in ESM and BBS apparently involved term repurchase

~/ For a discussion of automated systems for the transfer of 90vernment-relatedsecuri~ies, see infra notes 48-49 and accompanying text.

- 25 -

agreements. Comment is requested as to whether there is a

similar risk of abuse in overnight repurchase agreements.

Finally, comment is requested as to the need to impose any ,

collateralization requirement on banks or regulated broker-

dealers already subject to examinations and segregation

requirements.

Also, please consider possible alternatives to col-

lateralization, such as a requirement that a dealer se9re9ate

its customers' collateral. Would the viability of such a

customer segregation requirement depend on an auditor's

examinations, or the ability of the customer or a re9ulatory

body to inspect or externally audit the dealer's accounts?

Evaluation·of possible means of providing such an external

check is requested. ~/ Comment also is requested on whether

it is necessary or appropriate for the re9ulators of institu­

tional investors to adopt rules to ensure thatth~y follo~

such protective measures.

25/ The Commission also seeks comments on whether specific measures such as the expansion of book-entry systems in government securities would be useful in ensurin9 that investors can obtain adequate collateralization in connection with repurchases and similar short-term transactions. In this connection, the Commission seeks comment on whether adequate collateralization would protect investors from abuses apart from possible dealer insolvency, or whether some additional guidelines or regulations directed towards dealers engaged in a 90vernment securities business might be necessary. See infra notes 26-33, 37-66 and accompanying text.

- 26 -

3. Expansion of Statutory Disqualification Provisions .

Another approach which could be used alone or in conjunc-

tion with other approaches would be to expand the present

authority to suspend or bar securities market participants.

Currently, SROs under the Commission's jurisdiction are

empowered to deny membership to a broker-dealer registered with

the Commission and bar ~ny person from becoming associated with

a registered broker-dealer who is subject to a statutory

disqualification. ~6/ The SRO must file with the Commission

a notice· within 30 days if it knows, or in the exercise of

reasonable care should have known, that it has admitted into

membership a person subject to a statutory disqualification'

or allowed a person subject to a statutory disqualification

to become associated with a member. ~2/

~/ Section 6(c)(2) and l5(A)(g)(2) of the Exchange Act. See also Section l5B(c)(4) of the Exchange Act. The term--statutory disqualification- is defined broadly in Section 3(a)(39) of the Exchange Act to include, among other things, persons: expelled, suspended from membership in, or barred from association with, a member of an SRO~ Subject to a Commission order suspending or revoking broker-dealer registration~ or who have violated the federal securities laws.

Rule 19h-l under the Exchange Act.

- 27 -

The Commission notes that, to some extent, the recent

problems in the government securities markets appear to have . . ,

resulted from certain persons connected with one troubled

dealer later moving to another dealer which subsequently

encountered difficulty. Accordingly, comments are requested

on the possibility of extending the review of persons subject

to a statutory disqualification to cover all dealers, including

currently unregistered government securities dealers. Please

also comment on whether such a review is feasible without

registration and ,examination of government securities dealers

to enforce such provisions~ and discuss whether this additional

oversight would be effective as the only additional regulation

of government securities dealers, or whether it could best be

utilized i~ conjunction with other regulatory initiatives.

4. Expansion of FRBNY Guidelines

An alternative regulatory approach could be the use

of voluntary guidelines governing the conduct of firms

.. engaged in a government securities business. For example,

the FRBNY's proposed voluntary capital adequacy guidelines

~~uld be expanded to establish standards in other areas

such as the segregation of customer securities and the

maintenance of complete books and records. Alternatively,

voluntary guidelines could be adopted by a relevant industry

- 28 -

9rouP. The FRBNY's proposed voluntary 9uidelines rely on

pressure to comply from customers, and indirectly, from

re9ulatory agencies requirin9 supervised ins~itutions

to ensure compliance by the firms with whom they deal.

Complyin9 firms would obtain certification of compliance

by an independent public accountant, thus providin9

customers with a basis on which to ehoose the firms with

which to deal.

The Commission seeks comment on whether volunta~y 9uide­

lines for 90vernment securities dealers could adequately

protect investors and. maintain the inte9rity of the govern­

ment securities markets. In this connection, it would be

useful if commentators would assess the potential cost-effec­

tiveness .of the FRB's current reporting program for secondary

dealers and the proposed voluntary compliance-program, as

well as whether the voluntary standards could be enhanced

by voluntary inspections, perhaps by a federal agency or a

relevant industry group, auditin9 of all affiliates by a single

auditor, or certification by auditors of internal controls as

well as financial statements. In order to be effective would

it be necessary for such standards to be mandatory?

- 29 -

,~ Creation of a Self-Regulatory Organization.'

Another oversight approach would be the creation of

an SRO for government securities dealers. Important issues

include: whether such an SRO should have rulemaking power·

only or also have inspection and enforcement powers over

members 1 ~/ and whether membership in such an SRO should

extend to all government securities dealers, or be limited

to non-bank dealers or unregistered firms that deal solely

in government securities. Any regulatory scheme for over-

sight of government securities dealers must recognize the

28/ At present there are two basic types of SROs: those with rulemaking authority only, such as the Municipal Securities Rulemaking Board ("MSRB"): and integrated SROs with rulemaking, inspection, and enforcement authority, such as the National Association of Secu­rities Dealers, Inc. ("NASD") and the national securities exchanges. The MSRB's fifteen-memb~r board with expertise on municipal securities has authority under Section l5B(b)(2) of the Exchange Act to adopt rules 90verning transactiona by brokers, dealers, and municipal securities dealers, subject to Commission approval. The MSRB is divided evenly amon9 representatives of dealer banks, securities firms, and. the public. Responsibility for ensuring compliance with MSRB rules, however, rests primarily with bank re9ulators for dealer banks and the NASD for re9i~tered broker-dealers. In contrast, the NASD and the national securities exchanges have inte9rated rulemakin9, inspection, and enforcement authority subject to Commission oversight, over re9istered broker-dealers and member firms, respectively. The Commission also has enforcement and inspection authority over the -entities subject to SRO rules.

- 30 -

important role of the primary dealers in the auction process

and the FRBNY open market operations, as well as the unique

oversight, role of the FRBNY with respect to the primary

dealers. Accordingly, comment is sought on whether the

primary dealers should be exempted from SRO membership or

subject to a more limited form of SRO oversight.

A government securities SRO could be a separate,

limited SRO, modeled after the MSRB~ or could be an expan-

sion of the MSRB to include responsibility for regulation

of the government securities market. ~/

A limited SRO which had rulemaking but not inspec~

tion or enforcement authority could take several 'forms.

The form most similar to the MSRB could have rulemaking

authority over all government securities dealers, including

banks and dealers registered with the Commission. Inspec-

tion and enforcement authority could repose in the bank

regulators for bank dealers, the FRBNY for primary dealers,

and the NASD or the New York Stock Exchange (WNYSE n ) for

non-bank dealer members.

A second form of SRO could be limited to adopting rules

applying to government securities dealers not regulated by

~/ This is the approach taken in the Public Securities Act of 1985, introduced on April 15, 1985 by Congress­man John Dingell and several other co-sponsors in the House of Representatives. See H.R. 2032, 99th Cong., 1st Sess. (1985).

- 31 -

any other SRO or agencYr It would not govern the govern-

ment securities activities of registered bank dealers and

registered broker-dealers. - Enforcement and inspection

authority over unregistered government securities dealers

could. be delegated to the NASD or the NYSE.

" Alternatively, a government securities SRO could be

given fully" integr~ted rulemaking, inspection, and enforcement

au.thority like that of the NASD and the national securities

exchanges. This integrated approach may provide greater

consistency between rulemaking and rule enforcement and

permit consolidation of expertise in a single entity. On

the other hand, an integrated SRO for all government secu-

ritie"s dealers might be duplicative in part. 30/

Another approach which could be used alone or in conjunction

with the creation of an SRO for currently unregulated government

securities dealers would be to expand the jurisdiction of an

existing SRO to include government securities dealers. For

instance, all or certain government securities dealers could be

brought within the purview of the MSRB, the NASD, or the national

30/ The Commission requests that commentators discuss whether an integrated SRO might nevertheless be ap­

. propriate for sole government securities dealers which, if they are not primary dealers, currently are not subject to any form of regulation. The principal advantage of the limited SRO model is that it avoids creating an additional inspection and enforcement structure for currently regulated e-nti ties.

- 32 -

stock exchanges. This approach could include a requirement that

subsidiaries of registered broker-dealers be combined with the

registered broker-dealer or that broker-dealer audits and in-

spections extend to government securities dealer subsidiaries.

Such an approach might substantially reduce the start-up costs

of a government securities SRO. Because these SROs are not

presently oriented toward government securities, however, they

might have to revise their organizational structures and examine

the applicability of their rules in order to regulate effectively

government securities dealer activities. 1!/

The Commission asks commentators to evaluate the cost-ef-

fectiveness of these various forms of self-regulation. Comment

is sought on whether self-regulation is appropriate for the

government securities markets on the whole, and whether the

benefits from uniform rulemaking for the government securities

industry would outweigh possible costs of compliance. 32/

Commentators also should assess whether subjecting less than

The Commission also notes that, pursuant to Section l7(d}(l} of the Exchange Act and Rule l7d~1 thereunder, the Commission has the authority to allocate authority to SROs in areas of potential overlap. The Commission requests comment on whether, if government securities regulation is accomplished through an SRO, the Commis­sion should use its authority under this section to allocate regulatory responsibilities. It also should be note that, under Rule l7d-2, SROs can agree to al­locate responsibility for examining dual members' compliance with SRO and Commission requirements to one of the SROs.

In this connection, the Government-Related Securities Report attempted to assess the costs of an SRO approach. See Government-Related Securities Report, supra note 4, ~232-234.

- 33 -

I

all dealers to self-regula:tory oversight ·mig·ht unfairly

burden the firms subject ,to this oversight by creating.

regulatory dispari tles. ,Commen·t is also requested as. to

whether any of the other p·ossible SRO :models ·may have

adverse competitive effects on anysector.of government¥

securities dealers.

6. Direct Federal Regulation

A further alternative is increasing .the direct federal

role in regulating the government securities markets. Govern-

ment securities dealers could be·required to register directly

with the Commission, as ,is currently required of registered

broker, dealers, and municipal· securi ties dealers., the FRB,

or s~me other entity, and be directly subject to federal

regulations concerning financial responsibility and other

subjects discussed below. 33/· Another· possibility would

be to give to the FRB the direct ability to regulate the

qovernment securi ties market, thus strengthening its pre,sent

informal oversight activities. This alternative could

operate separate from or in conjunetion with other approaches

to overseeing the government securities market.

7. Federal Oversight

A further issue raised by the consideration of additional

regulatory structures is what form of ultimate federal over-

sight should exist. One approach could be for either the

33/ See infra text accompanying notes 37-63.

- 34 -

Commission or the FRB to have sole oversight authority' over

a government securities SRO or other regulatory st~ucture.

~he Commission and the FRB each have experience in different

areas that might pertain to such an SRO or regulatory structure.

~he Commission has substantial experience in overseeing a

variety of securitiesSROs, including the MSRB, the NASD, and

the national securities exchanges. It is the appropriate

regulatory authority for broker-dealers, and is charged

with responsibility for administering the federal securities

lawa. In that capacity, it currently has anti-fraud authority

over participants in the government securities markets. The

PRB has substantial expertise with respect to the government

securities markets. The FRBNY already is active in monitoring

closely the activities of primary dealers, receives information

from other dealers on a voluntarr basis, and is responsible for

implementing national monetary policy through transactions in

govern_ent securities. Accordingly, the Commission seeks comment

on the appropriateness of sole FRS or Commission oversight.

- 35 -

Another possibility would be joint supervision of an SRO

by the Commission, the FRB, and the Treasury. This approach

was proposed in the Government-Related Securities Report.

This ~~ersight could operate either directly through a joint

councilor through consultation procedures similar to those in

clearing agency regulation under Section l7A of the Act 34/ or

between the Commission and the Commodity Futures Trading Com-

mission under the Commodity Exchange Act (-CFTC-SEC AccorQ

model W). 35/ The Commission solicits comment on the relative

advantages of these various oversight approaches.

35/

See Section l7A(a)(2), (3)(A) of the Exchange Act. Under the clearing agency model, one agency would be the .principa~ oversight agency, and would consult and cooperate with other interested agencies to insure that each fulfills its respective regulatory respon­sibilities, especially when proposed SRO rules are involved. In addition, interested agencies would make and ~nforce their own rul~s with respect to government securities dealers over whom they have jurisdiction. ' .

Securities Exchange Act Release No. 20578 (January 18, 1984), 49 FR 2884. Under the CFTC-SEC Accord model, orie agency would be the principal oversight authority, and ~ther agencies would be able to comment upon and in certain instances veto action taken by the principal authority.

- 36 -

B. "Areas of Regulation

In conjunction with determining whether further federal

oversight of the government securities market would be cost-

effective, comments are requested on the areas such regula~

tion should cover. In its regulation of brokers, dealers,

and municipal securities dealers (both directly, and through

its oversight of the SROs), the Commission in the past has

developed and reviewed regulations in three general areas:

(1) financial and operational regulation: (2) professional

qualification regulation: and (3) business practices regula-

tion. ~§/

36/ As discussed above with respect to the scope of SRO and federal ~versight of goverhment securities dealers, see supra text accompanying notes 28-33, the Commission recognizes that, even if additional regulation of the government securities market is . deemed to be cost-effective, some of these types of requirements may not be found to be applicable to all go~ernment securitie~ dealers. Accordingly, the Commission requests commentators to address each of the areas of possibie regulation and to discuss the costs and benefits of imposing such regulations on various participants in the government securities markets. The Commission further requests commenta­tors to describe any specific operational charac­teristics of the government securities markets that may be relevant to a discussion of whether a particular aspect of regulation is cost-effective.

- 37 -

1. Financial and Operational Regulation

The cornerstones of the.Commission's financial regula­

tion of brokers and dealers are the Net Capital Rule 37/ and

the Customer Protection Rule. 38/ The primary objective of

the Net Capital Rule is to ensure the liquidity of a broker­

dealer to enable it to meet its obligations promptly. The

Customer Protection Rule has two principal objectives: (1)

to require a broker or dealer to obtain promptly, and

thereafter maintain, possession or control of customers·

fully paid and excess margin securities~ 39/ and (2) to

require brokers and dealers to deposit, in effec~i excess

customer monies in a special reserve bank acco~nt for the

exclusive benefit of such customers. 40/

The Commission requests comment ~n whether this type of .

financial regulation should be applicable to government secu­

rities dealers and, if so, at what level the reqtiirements,

37/ Rule lSc3-l under the Exchange Act.

38/ Rule ISc3-3 under the Exchange Act.

39/ Rule lSc3-3(b) under the Exchange Act.

40/ Rule ISc3-3(e)(2) under the Exchange Act.

- 38 -

particularly net capital requirements, should be established.

It would appear that the impact of many of the recent govern-

ment securities dealer failures would have been lessened con-

siderably if there had been a functioning net capital rule in

pl~ce and audits or inspections had detected the significant

trading and other losses incurred by those firms and- related

firms. At the same time, the substantial leverage in the

government securities industry, and the selective absence of

significant capital reserves for many firms, suggests that

caution would have to be exercised in applying any financial

responsibility standards in this market. In this context,

the Commission specifically requests commentators to discuss

theFRBNY's proposed voluntary capital adequacy standards 41/

and whether any capital standards should be made mandatory. 42/

The Commission also requests commentators to discuss

whether there should be specific margin requirements imposed

on transactions in government securities. The Commission

requests commentators to consider direct Federal regulation

~/

~/

See supra note 8.

The Commission also requests comment on whether there should be periodic financial and operational reporting by government securities dealers in a manner similar to the FOCUS Reports filed by registered broker-dealers on Form X-17A-5 under the Exchange Act.

- 39 -

of margin, such as that engaged in by the FRB under Se'ction 7

of the Exchange Act with, respect to transactions in corporate

securities, 43/ or, 'alternatively, margin regulations

established by an SRO, subject to government oversight, 44/

or SRO,margin regulation that is not subject to any formal

government oversight~ ~/

Many of the recent problems in the government securities

markets have inv()lved repurchase transactions~ Hence, the

Commission requests comment on whether it is desirable to

establish specific financial and operational regulations

governing the repurchase agreement market. For example,

should there be regulations concerning the collateralization

~/

~I

45/

See Regulations G (12 CFR § 207): '1' (12 CFR '§, 220): U m CFR § 221): and X (12 CFR §224) promulgated by the FRB.

, "

Margin regulation established by an SRO, subject to government oversight, would be similar to the manner in which margin requirements currently ~re established for options on stock indices, debt securities, and foreign currency, and in which. they have been proposed to be established for individual stock options. SeeFRB Docket No. R-0538. Various alternative approaches toward margin regulation are discussed in an extensive recent study by the FRB staff. See FRB, A Review and Evaluation of Federal Margin Regulations (December 1981).

For example, margins for futures are established by the board of trade, and the CFTC is statutorily' precluded from reviewing those margins. See Section 5a(12) of the Commodity Exchange Act.

- 40 -

of repurchase transactions? ~/ In this regard, what regula­

tions should be adopted, and what-eh~nges shotild b~made to

existing regulations governing either book-entry, physical

delivery, or segregatio~ of collateral for these transactions?

Also, should the extent of regulation vary according to the

duration of the transaction?!Z1 Finally, should there be

specific regulations governing mark-to-market payments in these

types of transactions?

With respect to regulation of the operational and proces-

sing aspects of the government securities market, the Commis-

sion first notes that evidence of ownership of Treasury bills-

is now solely in book~entry for~ and that settlement in

these securities occurs by electronic communication systems.

Beginning 1n 1986, all new issues of Treasury bonds and notes

also will be issued and traded in this manner. In addition,

the Commission notes that the MBS Clearing Corporation (nMBSeC·),

a subsidiary of the Midwest Stock Exchange, was established in

1979 to offer settlement services to firms active in the GNMA

market. In March 1985, MBSCC, in conjunction-with Chemical Bank,

also began offering depository services on certain GNMAs. 48/

46/

47/

48/

See also supra text accompanying notes 24-25.

The Commission also request~ comment on whether specific regulatory programs are necessary to address other particular types of transactions in government securities, such as GNMA forward and standby transactions.

The Commission understands that GNMA recently has indicated interest in the development of a book­entry system for GNMA securities and has stated to MSBCC that, should its depository prove viable,

(footnote continued)

- 41 -

Asa ge~eral matter, however, most transactions in government-

related securities are not processed in an automated environment.

On February 25 and 26 and March 8, 1985, the Commission

hosted a series of workshops on increasing the immobilization,

and ultimate elimination, of securities certificates. A primary

focus of the workshops was to identify steps that could be pursued

to immobilize or eliminate certificates in the government-related

securities markets. Virtually unanimous support was expressed

for developing book-entry or similar systems. The Commission

currently lacks direct authority over clearing agencies or their

participants engaged exclusively in processing of such securities.

Accordingly, the Commission requ~sts comment on what regulatory

action, if any, is appropriate to facilitate more efficient

processing of government securities •. Commentators are requested

to focus both on the long-term adequacy of current book-entry

processi~g system, especially if trading volume greatly increases

in these instruments, and on the need for automated clearing

facilities in instruments not issued solely in book-entry form. !2/

(footnote continued)

~/

it was ine~rested in holding discussions with MBSCC on further measures to streamline efficient operation of the GNMA market. Ginnie Mae will Use MBS for Clearance of its Securities, Bond Buyer, April II, 1985.

In considering this area, the Commission notes that the MSRB recently adopted rules requiring municipal securities brokers and dealers to use the facilities of a clearing agency for clearance of transactions in municipal secu­rities if they are members of one or more clearing agencies that offer such services. MSRB rule G-12(f).

- 42 -

The Commission also requests comment on the need for

.specific record retention requirements to facilitate inspec-

tions programs. While inspection programs are an essential

portion of any direct regulatory scheme, the question of who

should conduct the inspection has be~n raised previously.

A final issue relating to financial and operational

regulation relates to insurance or similar protection for cus-

tomers of government securities dealers that enter liquidation.

Specifically, the Commission requests comment on whether the

Securities Investor Protection Act of 1970 (WSIPAW) should·

be extended to p~ovide protection to customers of government

securities dealers not currently registered with the Commis-

sion. SOl If so, commentators are requested to consider whether

the current levels of coverage provided under SIPA would be

cost-effective for government securities dealers, or for losses

from government securities transactions by broker-dealers. 511

~I

511

The Commission notes that government securities positions held by customers of registered broker-dealers who also conduct a government securities business currently are protected by SIPA in the event of the default of the broker-dealer. Nevertheless, the Securities Investor Protection Corporation (·SIPC·) takes the position that persons engaged in repurchase transactions with SIPC member firms. are not customers under SIPA and therefore are not protected by SIPA. In the event that SIPA did apply to the repurchase transactions, would SIPC have adequate funds to satisfy customer claims?

If the property in possession of a failed broker-dealer that is distributed to customers is insufficient to satisfy customer claims, SIPC advances funds up to $500,000 per customer, of which no more than $100,000 can be to satisfy claims for cash.

- 43 -

2. Professional Qualifications

Persons associated with registered broker-dealers must

meet professional qualification standards. The Act specifically

empowers SROs to ensure the qualifications of persons associated

with member firms. 52/ One aspect of professional qualifica­

tions is the requirement to pass an examination testing

knowledge relevant to particular functions in the industry. ~/

In addition, SROs are empowered, subject to Commission review,

tod~~y~embership to a broker-dealer, and bar any person .

from becoming associated with broker-dealers~ who is subject

to a statutory disqualification. 54/

54/

See Sections 6(c){3)(B), lSA{g)(3){B), and lSB(b)(2)(E) of the Exchange Act.

See NASD By-Laws, Article I, §§ 1-2 and Schedule C thereunder (WSchedule CW)~ MSRB rules G-2 and G-3~ NYSE Rule 345. For example, registered representa~ tives must pass either: (i) the Series 7 General Securities Representative Examination, Schedule C at III (2)(a), to qualify to conduct a general securities business~ or (ii) a more specialized examination, or examinations to qualify to conduct specific limited types of business. Specialized examinations include the MSRB's Muncipal Securities Representative Examina­tion, MSRB rule G-3{e), and NASD Limited Representative examinations for direct participation programs, Sche­dule C at III (2){c), investment company and variable contracts products, Id. at III (2)(b), and options products, Id. at IIr-T2)(d). Similarly, supervisory personnel must pass the relevant principal examina­tions. These examinations generally parallel the categories of examinations applicable to registered representatives, with additional examination, such as one for fin~ancial and operational principals.

See supra notes 26-27 and accompanying text.

- 44 -

The- Commission requests comment on which, if any, of

these professional qualifications requirements should be

applicable to the government securities markets. In doing so,

commentators are requested to address what particular supervisory

requirements would be cost-effective in the governmentsecuri-

ties market and whether persons with particular statutory·

disqualifications should be restricted from participating in

this market.

3. Business Practices

Pursuant to the statutory directive to adopt rules to

prevent fraudulent and manipulative acts and practices, to

promote just and equitable principles of trades, to protect

investors and to further the public interest, 55/ SROs have

adopted a number of rules regulating various business practices

of their members. In addition, the Commission, pursuant to the

55/ See Sections 6(b)(S), l5A(b)(6), and l5B{b){2)(c) of the Exchange Act.

- 45 -

anti-fraud sections of the securities acts, 56/ has adopted various

rules and adopted enforcement programs that addres~ the business

conduct of broker-dealers.

While some of the business practice rules adopted by the

Commission and the SROs had, as their original basis, the objec­

tive of assuring that broker-dealers protected themselves against

unsound practices, for the m~st part they have evolved into ~ules

d~signed to protect investors dealing with those br~ker-dealers.

In considering the appropriateness oi applying busiriess practice

rules to government securities dealers, it is necessary to

understand the nature of the customers with whom they typically

do business.

A significant presumption b~hind a number of provisions of

the federal securities laws and Commission rules is that, as the

financial resource~ of an investor increases, his need for pro­

tection under the federal securities laws decreases, primarily

because the sophistication of the investor, or ~is ability to

56/ . See sections lOeb), l5(c)(1),and l5(c)(2) of the EXChange Act and l7(a) of the Securities Act.

- 46 -

obtain professional advice or counsel, commensurately increases. 57/

Transactions in the market for government securities generally

are substantial in size. Nevertheless, abuses that have come to

light in the past in the government securities markets generally

have involved entities regarded as -institutional investors,-

often financial institutions. 58/ Accordingly, a significant

question raised by problems encountered in the government secu­

rities industry is whether the presumption of sophistica~ion

usually attached to investors with significant assets is ap-

plicable to investors in the government securities markets, or

whether the complexity of transactions or other factors related

t~ this market nec~ssitate additional protection for otherwise

sophisticated investors. As a related matter, if it is felt that

these customer losses stem from sophisticated irivestors that have

received inadequate management or ~dvice, c6mmentators are asked

to consider whether additional regulation of these investors

by their regulators, or other approaches such as the FRBNY's

educational initiative, would be more cost-effective than, or

preferable to, regulation of government securities dealers.

The Commission requests commentators to focus on a number

of specific areas where business practic'e rules have been adopted

57/

58/

See, ~, Rule 215 under the Securities Act, defining the term -accredited investor" as used in Section 2(15) of'the Securities Act and Rule 215 thereunder: and Section 205 of the Investment Advisers Act of 1940.

See, ~, Government-Related Securities Report, supra note 4, at 106-117.

~47 -

in the past." First, those SROs that regulate registered

broker-dealers have rules to ensure that members recommend to

a customer only .securi ties that. are sui table for tha t customer. 59/

Similarly, these rules also addiess ·churning,· or engaging

in excessive trading solely to generate commissions. 60/ In

the past, the most rigorous suitability rules have been

intended to address potential problems involving speculative

low-priced securities, securities where market information is

unavailable, or potentially risky trading strategies involving

options.

Government securities in and of themselves pose virtually

no credit risk to investors. Nevertheless, trading vehicles

such as repurchase agreements, reverse repurchase agreements,

GNMA forwards and standbys, and when-issued trading may pose

suitability issues. Bence, the Commission requests comment

on whether suitability concerns are raised in the more complex

trading strategies involving government securities.

Se~ond, the Commission and the SROs have rules governing

disclosure that must be made in confirming trades with customers. 61/

59/

§.2./

!!/

See NASD Rules of Fair Practice Article III § 2~ MSRB rule G-19.

See NASD Policy of the Board of Governors: Fair. Dealing With Customers, under Article III § 2 of the NASD's Rules 'of Fair Practice.

The confirmation rules generally require certain informa~ tion to be disclosed ~o customers, including, with respect to debt securities, dollar value and yield information and, where applicabl., information co~cerning possible redemption before maturity. Commission Rule lOb-10~ NASD Rules of Fair Practice Article III Section 12: MSRB rule G-1S.

- 48 -

The Commission requests comment on~whether thefesbou~d. be'

specific confirmation requirements applicable to the govern­

ment securities markets, for ex~mple,as.regards t~,~h~

general provisions of repurchase_agreement~ •.

Third, pursuant to its,gerieral investigative and anti­

fraud authorJty, the Commission investigates, and can take '. enforcement action, if it believes that customers are ~eing

charged excessive mark-ups or commissions, 62/ incl.uding trans­

actions in government securities. 63/ The Commission requests .

comment on whether reliance on·the Commission'.s gen~ral anti-

fraud authority.is sufficient in this area or whether there ~ . ",

should be more specific regulation of commis~ions ~nd ~ark-ups ~

of government securities.,

Finally, the Commission request~ comment·o~ ~ny other

business practic,e regulations that commentators may belie.ve . '

62/ In addition, SROs have m6re spec~fic rules intended. to ensure that their members ar~ not charging extessive mark-ups and commissi~ns in non-~xempt ,securities~ . NASD Rule~ of Fair Practice Article III § 4~ MSRB rule G-30. Those SROs.with surveillance and enforcement' authority also inspect for violations of the rules, and can take action in appropriate circumstances •

. The Commission has used this authority on severai occasi<;ms to bring ,enforcement actions wi ~h resp,ect. to government securfties •. ~, ~.' SEC 'v., Winters Government Securities Cor oration (S.D. Fla., No. 77 Civ. 6345 , Litigation ReI. No. 8061' (August 15, 1977), 12 SEC Doc. l560~ SEC v. MY Securities, Inc. (S.D.N.Y., No. 84 Civ.',1164), Litigation Rels. Nos.--ro289 (Febru­ary 21, 1984) and 10303 (March 5, 1984), 29 SEC Doc. 1454 and 1591. .

~ 49 -

are appropriate. Areas of possible comment include, but are

not limited to, disclosure of possible conflicts of interests,

regulations concerning quotati~n_and last sale reporting, and

rules regarding employee trading.

III. Conclusion

In preparation of its response to Congress on the need

for additional regulation of the.government securities marke~s,

the Commission is seeking comment on a wide variety of issues~

The Commission requests commentators to address both the

specific issues raised" in this release and any other issues

believed to be relevant to the government securities markets.

LIST OF SUBJECTS IN 17 CFR 240

Reporting and recordkeeping_requirements, securities

By the Commission.

Date: April 19, 1985.

John Wheeler Secretary.

Exhibit 2

Summary of Comment Letters

In response to its solicitation of comments on the appropriate

approach to regulation of the government securities'market, the Com­

mission rec'eived 79 comment letters, inciuding' 23 from primary dea­

lers or organizations representing these dealers, 22 from secondary

dealers, and 12 from investors and investor groups. In general, 56

commentators supported at least some form of additional'federal regu­

lation for the government and/or agency securities markets, '12 com­

mentators opposed any form of further regulation, andll expressed

no opinion.

Commentators were uniform in their' view that the U.S. government

securities market is the world's largest, most efficient and liquid

securities market. Most also noted the importance of this market in

financing the government's debt as well as permitting the Federal

Reserve Board (nFRBn) through the Federal Reserve Bank of New York

(nFRBNyn) to execute domestic monetary policy. Both pro and con

commentators stressed the dangers of imposing excessive regulation

that would impair the liquidity of the market, raise treasury and

dealer costs, and lower yields to investors.

Many commentators responded to specific questions raised by

the Commission, including the impact of the ESM/BBS failures' on

the market, the costs/benefits o{ regulation, and the structure

and coverage of regulatory proposals, particularly relating to

repurchase transactions (repos)."

I. Impact of the ESM/BBS Failur~s on the Market

The City of Pompano Beach, Florida, which may ,lose $11.9 million

after the fall of ESM, cites, along with numerous other commentators,

- 2 -

an overall loss of investor confidence in the market. The City also

perceived the recent Maryland thrift difficulties to be directly re­

lated to this loss of confidence. The FDIC indicated that 16 insured

state nonmember banks had open transactions with ESM or BBS, which

may result in up to $12.4 million in losses (one bank may incur much

of this loss).

The Federal Home Loan Bank Board (nFHLBB") indicated it

may require its insured savings and loans to deal with regu­

lated dealers (many regulated and unregulated investors are

independently reviewing their trading controls and procedures)

and might impose a strict mark-to-market policy. Many com­

mentators cite that more market participants are ~crutinizing

the credi~worthiness of those with whom they deal. Many pri­

mary and secondary dealers perceive a flight to quality, a

shift of business from small regional firms to primary dealers

or more capitalized secondary dealers. There is evidence of

even a flight from unregulated or smaller capitalized primary

dealers to regulated or larger capitalized primary dealers.

The greatest impact has occurred in the repo market. Many

dealers indicate that more customers are seeking delivery or at

least some form of collateral perfection. Some unsophisticated

institutions have left the market (may have been forced into

more speculative markets, ~, commercial paper) resulting in

less business for the smaller regional firms. Indeed, the City

of Pompano stated that although it had done over 2,000 repos during

- 3 -

the past five ye~rs, after ESM it has done none. The City indicated

that it re~eives lower yields in its present alternative investments,

which may cost the City up to six figures in lost annual interest

income.

II. Regulatory Proposals

..... The vast maj or i ty of commentators recommended some form of fur-'. . . .

ther federal regu~ation over government securities market participants.

All six investors were strongly in favor of additional regulation.

Most propon~.nts of regulation touted the benef its of regulat ion as

restoring public confidence in the market, thereby increasing dealer

and investor participation and liquidity, promoting long term market

stability which will reduce national debt financing costs, protecting

customers, and reducing potential losses and deterring frauds. Other

commentators alluded to the failure of voluntary standards with re-

spect to the market's recent problems. While commentators varied

~idelyon_the structure and coverage of the regulatory scheme, com~

menta~ors generally cautioned that the new regulation should be fo-0', 1

;~cu~sed ?n ~olving the recent problems with the market. '" .-:: . .,

',c A. G.eneral Rulemaking/Enforcement Proposals

A significant number of commentators, including most primary

dealer~, supported the regulatory ~pproach extended by the Primary

Dealers Committee of the Public Securities Association ("PSA").

The PSA's comment letter tracked the earlier testimony of the

Committee's Chairman, Richard Kelly. The PSA advocated that the

FRB be vested with, rulemaking authority (so long as it consulted

- 4 -

with the Treasury and other appropriate regulatory agencies) over

all government securities dealers. The FRB should promulgate

rules, which would include a registration requirement, capital

adequacy standards, inspection and enforcement procedures, and

specific measures to prevent fraud in connection with repose

The PSA advocated that the FRB should be given exemptive autho­

rity and should account for the unique role of the' primary dea­

lers in structuring its rules. The association also believed

that it was important that prudent investment standards be estab­

lished to guide less sophisticated investors. Finally, the PSA

opposed any requirement that would mandate delivery of repo col­

lateral, vie~ing such a requirement as imposing unnecessary ~osts,

" "especially for non-wireable securities. The association believed

that segregation of collate~al should be permitted as an alternative

to delivery.

While the PSA pOSition only hinted that additional regulation

should fall mainly on secondary dealers as opposed to primary dea­

lers, some commentators, including many primary dealers and the

u.s. House of Representatives Subcommittee on Domestic Monetary

Policy ,of the Committee on Banking, Finance and Urban Affairs

("House Subcommittee"), directly asserted that new regulations

should exclusively cover unregulated dealers (due to the percep­

tion that recent problems stemmed from these dealers). Still,

many commentators urged the extension of uniform regulation to

all dealers. In this connection, the Mortgage Bankers Association

. ,.,

- 5 -

of America argued that secondary dealers would be disadvantaged

if they were the only dealers l~ubj ect to the new regulation. -1./

Most commentators who focussed on who should receive rule-

making authority chose the FRB as a result of its close and·

historic nexus~to the the government securities market. In

this regard, th,e. House Subcommittee, NYSE and Morgan Bank sug­

gested that an advisory bpard within the FRB be created to

advise the FRB in promulgating rules. While three commentators

would give the MSRB rulemaking authority, most objected because

of the dissimilarities in the markets for municipal and govern-

ment securiti~s,i'~, different investors, problems, etc. -.1/

Three =[:',ec.Qmmended the, creation of a new SRO (GSRB) under the

aeg is of the FRB and made, up of federal government partic.ipants (II ••

and/or industry/investor participan~s (Irving Trust suggested

.that a new SRO comprised of formerly unregulated dealers should

.-!.I The law firm of Patton Boggs & Blow, representing Lazard Frer,es, a secondary dealer, submitted a comment letter arguing the competitive disadvantages of secondary dealers being unable to access primary dealer brokers' brokers s~reens for trading and pricing securities. The firm advocated al~ ternative credit tests to gain access to the screens and downplaying the importance of primary dealer status~

-.11 The Credit Union National Association, Inc., representing over 18,000 credit unions nationwide, suggested that representatives of the Treasury and FRB could be voting members of the MSRB, thus "balancing the federal agencies' responsibilities for the public debt and monetary policy with the self-regulatory approach of the MSRB."· .

- 6 -

conduct member inspections). Commentptors opposed to the latter

proposal cited the costs of a new SROand its potential tendency

to over-regulate. Many commentators, however, indicated the

benefit of using existing SROs to conduct inspections and.to

enforce FRB rules.

Several" commentators suggested. uI:lique regulatory schemes

whereby the FRBos rules would be voluntary, but the FRB would

be required to disclose those not in compliance with the rules.

For instance, Goldome, a market participant, suggested that the

FRS disclose those dealers who do not volutarily report their

.positions. The House S!.!9,committee suggested that the FRB

publ ish the names of those dealers not comp}-,y ing w'i th the FRBNY ° s

capital adequacy rule and that federally insured depository ~t tj

investors be barred from dealing with these dealers.

Although some primary dealers believed that the FRB should

make and ·enforce its rules for primary dealers, most comm~ntators

would permit the FRB to delegate enforcement and inspection func-

tions to others. Most suggested that these functions be under-

taken .by a particular dealer ° s current pr imary regulator, ~,

Commission,NASD, or banking agenay, with current unregulated

dealers being picked up by the Commission or NASD. Lehman Govern-s::;

ment Securities suggested that current unregulated secondary dea-

lers should be registered as broker-dealers with the Commission

and regulated as existing full service broker-dealers.

- 7 -

There was a fair amount of consensus on the types of rules

that the new regulation should encompass. Most favored a regi-

stration requirement for firms and professional staff (with a

possible grandfathering of the latter), statutory disqualifica­

tion rules, daily, weekly and monthly position reporting to the

FRB or an appropriate agency, auditing and inspection of books

and records requirements, financial reporting rules, and a

mandatory capital adequacy rule. With respect to a capital

adequacy rule, many would simply make the FRBNY's voluntary

guidelines in this area mandatory. Three stressed the impor-

tance of implementing a new rule sensitive to the government

securities marke~.(Merrill Lynch Capital Markets~ Bear . .

Stearns, and Lehman Government Securities.)

Many commentators were against suitability and other business

practice rules (they noted that the market was not characterized

by innocent individuals), SIPC cove~age, and margin requirements.

Although most agreed that investor education programs, whose 1

purpoSe is to raise the level of investor sophistication, by them-~

selves would not be effective,_such program~ and related rules

would be valuable adjuncts to dealer regulation. Metallgesell-

schaft Trading Corp., a reporting secondary dealer, sug~ested

that investors be required to take exams (Dillon, Read, another

secondary dealer suggested that at least money managers be re­

quired to take an exam) and sign dealer forms which disclose

":~ ."

8

market risks. Lasater & Coo, a secondary dealer, encouraged

investorsO regulators such as the FHLBB and FDIC to learn more

about their regulated investors Q market problems and establish

appropriate guidelineso -11 Indeed, the Securities Industry

Association ("SIA") recommended that the FRB issue guidelines - ,

to govern" investors 0 investment pract ices. First Boston ind i-

cated that certain problem investor groups should be targeted

for regulation. Goldman Sachs, a primary dealer, cautioned, ~,

however, that r~gulatprs should not overly react to the

recent problems and limit particular groups of investors to

overly restrictive policies such as dealing with only primary

dealers or dealers with a huge capital position.

Most commentators specifically discussed regulatory initia-. ~. . ,

tiv~s for. reposo While some investors and deal~rs advoca~e~L

a mandatory collateral delivery requi~~ment at least for wire .. -I' .

eligible securities, most commentators ~ncouraged expansion of

_1/ The State Comptroller ,of New York indicated that it had al­ready imposed strict in~estment guidelines upon the state's local governments in December 1984 after losses sustained in the collapses of Lio~s Capital and RTD. The Comptroller stated that "one state can not do it albneo Po~itive cor­rective action should ~k initiated by the Federal Govern­ment to control the market in which its securities are sold." The Comptroller urged that the Commission be given the authority to regulate government securities dealers; absent regulation, the Comptroller is considering prohibiting local governments from trading in the government securities market or' at least not with unregulated dealers.

- 9 -

book-entry and wire systems for all government and agency secu-

rities, but no mandatorj requirement that delivery must be made.

These commentators detailed the direct delivery costs ~/ and

argued the necessity of maintaining flexibility in structuring

repo deals 5/ (delivery may be prohibitively expensive for non­lk

wireable securities or short-term repos, especially those -.:

involving many underlying securities as collateral or a odd IN , .!.'

lot) •. In addition, many customers do not- have facilities to

take possession of collateral and must incur bank custodial

costs. The City of Pompano Beach cited its problems of arranging

with a correspondent bank to transfer its collateral, over the'

Fed wire. Because of its relatively low level of business, no

New York money center bank would set up a custodian account

for the City of Pompano Beach. In addition, local banking

~/

.2/

Irving Trust's comment letter described the direct and indirect costs of requiring delivery. Along with the $40 to $60 bank delivery charge (depending on the type of security and whether it was wireable, and including both wire and bank charges), most customers require custodial services for which banks charge between $15 to $50 per delivery. Delivery requires re-delivery after termination of the iepo, but once the collateral is out of the hands of the dealer, he risks delays in getting' it back resulting in a risk of failure to deliver. Bear Stearns noted that a $25 to $35 wire charge translated to 150 basis points lower yi'eld. for a customer in a $1 million overnight repo. Mortgage Bankers Association of America stated that a mandatory delivery rule for GNMAs would kill. the GNMA repo market.

Similar flexibility was recommended by some commentators with respect to the formulation of parties' margin prac­tices.

- 10 -

institutions did not feel they had sufficient :je_xpert~-hse I~P offer

that service. Bankers Trust cautioned that without flexi-

bilitiin setting up repos, dealers might be forced to seek

alternative financing that could cost 10 to 200 basis points

more than repo financing. Many commentators recommended alter-

native methods of allowing a customer to perfect a security in­

terest in the collateral besides delivery (~q verifiable segre­

gation rules and third party custodian arrangements. --2.1

III. Opposition to Regulation

The Department of Housing and Urban Development ("HUD") and a

small number of primary dealers, secondary dealers and other market

participants disfavor any mandatory federal regulation. HUD , ,.

believed that large scale r~gulation may reduce market liquidity

resulting in up to $2 billion in increased Treasury financing

costs per year. 21 BUD and some other com~ent;ators stated

that actual market losses may pale in comparispn to the costs

of regulation.

-.!I See the comment letters of Goldman Sachs and Irving Trust for,detailed descriptions of alternative methods of perfecting a security interest in one's collateral.

The House Subcommittee, although a proponent of compre­hensive regulation, cited a similar figure of potential costs of regulation. It noted that total FY-84 debt was $1.576 triilion and new financing and refinancing was $656.7 billion. If regulation raised costs by just 10 basis points (1/10 of 1%), the Treasury would incur between $1 to $2 billion in increased interest expense.

- 11 -

Like many proponents of regulation, opponents of regulation

argued that regulation will not prevent fraud, which is already

illegal. Some also argued that regulation may lull investors in­

to a false sense that the federal government is protecting them,

encouraging them not to exercise prudence on their own behalf.

These commentators believe that the market is self-correcting,

but mos~ encourage. adherence to voluntary industry standards such

as the FRBNY'svoluntary capital adequacy guidelines. They also

support educational programs to enhance the sophistication of

investors.

Many pro and con commentators believed that market partici­

pants must rely upon themselves to research the creditworthiness

of all parties with whom they deal and that the recent ESM/BBS

publicity has gone far to encouraging voluntary moves to more sound

business practices, including increased monitoring of repo collateral

and/or perfection of that collat.ral.

Dillon Read & Co., a secondary dealer, was particularly con-·

cerned about the imposition of a mandatory capital adequacy re­

quirement. The firm argued that such a requirement "would make

entry into the marketplace more expensive for small dealers and

therefore transfer increased risk to large dealers in the form

of reduced liquidity. The increased risk would mandate wider spreads

and more costly financing."

Summary·

Summary of May 21, 1985 Public Forum on Government Securities Market

Exhibit 3 .

The panelists in the Commission's May 21, 1985 Open Meeting on regulation of the government securities market represented ~ variety of perspectives on the government securities market -- investors, primary dealers, secondary dealers, industry groups, and federal regulators. Given this diversity, the panelists expressed a surprising degree of consensus. With only a few exceptions, the panelis~s supported a cautious legislative iriitiative that would grant the Federal Reserve Board limited authority to adopt capital adequacy and selected rules. The panelists felt strongly that such regulation of the government secu­rities markets was necessary to restor~ confidence in the markets ·and in dealers, particularly secondary dealers, to prevent dealer firm problems, and to protect less sophisticated institutional investors.

A number of commentators noted a contractiori in the repurch~se transaction ("repo") market and a tendency among investors to shun secondary dealers in favor of primary dealers as • result of the ESM and BBS collapses.· While John Niehenke of the Treasury indicated that this had not yet had a discernible effect on Treasury yields, others said that these trends could reduce the capital dedicated to these markets and thereby impair the liquidity and operation of the market. Commentators cited the unusually wide quotation spreads in GNMAs during the last three weeks as an example of this potential problem.

The most prevalent forms of regulation proposed wer~ registration requirements, some qualifications standards, capital adequacy standards, repotting and record keeping requirements, and regular f·irm inspections. Most panelists favored the Federal Reserve as the most appropriate rule­making body, with inspection and enforcement carried out by the Commission,. self~regulatory organizations, and bank

- 2 -

regulatory authorities. Three panelists supported a separ­ate government rulemaking board, or an expansion of the Municipal Securities Rulemaking .,poard to encompass government securities. .

Several panelists -- in particular, Mr. Ralph Peters of Discount Corp. and Mr. Niehenke, questioned the need for additional regulation. They suggested instead that education of investors and more careful regulation of investment practices might suffice to avoid repetitions of earlier dealer failures. Mr. Niehenke feared that regulation, even cautious regulation, could restrict dealer participation in the markets and reduce capital. The investor panel also generally was cautious about implementing broad regulatory changes •. ,

The pan~lists were divided on the efficacy of requiring delivery of collateral in repose Although one investor panelist, Mr. Cleveland, suggested a rule approach·that in effect would require delivery of coliateral in repos at the risk of losi~g exempt status for these trades, most dealers insisted that mandatory delivery of collateral would be difficult and excessively costly for smaller transactions (under $1 million) in wireable securities, and would be expensive and cause serious operational problems for non-wireable securi.ties such as GNMAs. These'panelists advocated relying on segregation rules and inspections to protect customers in repo transactions.

Separate discussions of each panel are providedb~low;

Investor Panel: (Bruce Cleveland, Government Investors Trust; Harold Boldt, II Columbia Missouri; Betty Dunkerley, ~I Beaumont, Texas)

Initially, the investor panelists expressed skepticism about the need for regulation in the government securities marketa. Instead, they focused on the need for investors to develop sound investment practices. In particular, they

"

-ll Mr. Boldt also is Chairman of the Government Finance Officers Association's cash management committee. He appeared in his individual capacity, not as a GFOA representative~

~I The city of Beaumont lost 62% of its total investments from its dealings with BBS.

- 3 -

emphasized the importance of: 1) taking delivery of col­lateral on all repurchase transactionsi and 2) educating the public investor about the nature and risks of repurchase transactions.

The panelists noted that regulatory measures such as capital adequacy quidelines would' not prevent fraud. But they acknowledged that a scheme of regulation including registration, inspections, surprise audits and enforcement authority would certairily deter fraud. Panelists favored such measures if they could be accomplished within the current regulatory environment by either the Federal Reserve Board or the Commission.

Mr. Cleveland estimated that the costs to convert a repurchase transaction from an unsecured loan to a govern­ment guaranteed security through taking delivery of the collateral were minimal - from three basis points for the largest investor to perhaps 10 basis points for the average investor. Mr. Cleveland acknowledged, however, that his fund maintained an average repurchase balance of $100 million doll~rs, making his costs very low. Panelists also noted that taking delivery of collateral is cost effective only for transactions of one million dollars or more, and that small investors often are discouraged by both primary and n6n-primary dealers from taking delivery of collateral.

Finally, Mr. Cleveland suggested that governmentsecuri­ties dealers that fail to deliver collateral on repo trans~ actions should not be exempted from the broker.dealer registration and regulation,re quirements of th~ Securities Exchange Act. Those dealers that deliver collateral would retain exempt status. 3/ The Fed would dete~mine through its book-entry system Which dealers were not making collateral' delivery and th~ Commission would exercise its enforcement authority.

Subsequent panels developed the riot ion of perfecting a security interest in collat~ral through m~ans other than taking delivery, particularly for the small investor. Those panels explored the possibility of pooled third­party safekeeping arrangements.

Primary Dealer Panel:

- 4 -

. . (Waite Rawls, Chemical Bank; Ralph Peters, Discount Corp; Edward Mahoney, Merrill Lynch GSI; J6n Corzine, Goldman Sachs)

The primary dealer panelists, with the exception o'f Mr'. Peters, bel ieved: 'immed iate regulat ion of' the government securities markets is necessary. All the panelists, including Mr. Peters~ beli~ved the PSA's proposal -- Federal Reserve rulemaking authority, registration requirements for dealers; capital adequacy standards, audits, and inspections by the NASD and the bank regu1at6rs -- is the preferable regulatory appr6ach.

The three pa~elists supporting regulation argued that there is a continuing problem with ma~ginal goverriment .securities dealers d~aling with unsophisticated customers, which threatens to destabil ize the market and .impair. investor conf id~nce. They indicated that investors have reacted sharply to th~se problems by shunning "even well-run secondary dealers, possibly forcing some of these firms ultimately from the market and reducing. capital and liquidity. These panelists also argued that cen­traliz~d rulemakirtgby the Fed was needed to forestali a proli­feration of restrictive regulation~ by other bodies (primarily the regulators of institutions lnvesti~g in the market) that could impede the governmen't secur i ties mar ket or destroy its fungibility.

. . The panelists all believed that the Fed was the preferable

rulemaking body because .of its involvement with the government . securities market through open.market operations, its experience in regulaiing banks, its present over~ight 6f th~.primary dealers, and its control of the book entry system.. They opposed expansion of the MSRB to the government securities markets because o'f the maj or differences in the gover'nment 'and municipal markets: for instance, the government securities markets have a far lower proportion of individual investors than the municipal securities markets. They also believed that establis~ing a new GSRB would lead to excessive rulemaking as the GSRB sought to justify its existence, although with the exception of Mr. Peters they viewed a new SRO as preferable to no regulation. They advocated NASD and SEC examination and enforcement authority over government securi~ies affiliates of broker-dealers, bank regulatory authority responsibility for banks, and Fed respon­sibility over the primary dealers and any remaining firms.

The panelists opposed any direct or indirect collateral delivery requirements for· repo transactions. They argued that wire transfer costs for small repo transactions in Treasury securities (under $1 million) would be prohibitively expensive.

- 5 -

They also indicated that the cost of physical delivery of non­wireable securities such as GNMAs far exceeded the delivery costs for Treasuries. For instance,' a single transfer of $1 million in GNMAs, consisting of 3 pools, would cost $75 - $100 , (resulting in a cost of 54 basis points for a one week repo). In addition, they contended that, at the current level of activity, delivery of collateral for all re~os would simply not be feasible. The panelists said that requiring collateral delivery would end smaller repo trades, hurt dealers and banks that relied on smaller trades, reduce liquidity, and widen spreads because of a shortage of financing. Mr. Rawls noted that collateral delivery through pooling arrangements for smaller trades could reduce these costs, but only if mandatory delivery was not required on 'a transactional basis. The panelists argued that the use of third party arrangements or segregation of collateral on a customer's behalf should continue to be allowed, as under the Commission's Rule l5c3-3, and that audits and inspections would give this segregation of customer collateral added rE!liability.

Secondary Dealer Panel: (Thomas Kane, Printon Kane: Griffith Clarke, G.X. Clarke; James Og9, Westcap Corp.: Stephen Barrett, Alex Brown)

The secondary dealer panelists strongly suppbrted regula­tion of the government securities ma'rk~:t, although they differed on what form regulation should take. ":Th~y~:,\un_j.formly emphasized that any regulation should treat primary and secondary dealers equally to avoid a further tiering of the market.

The panelists said that secondary dealers were suffering from a contraction in the repo market and from a blind nflight to quality· by investors in ,reaction to BBS and ESM. They said that many investors were choosing to deal only with primary dealers on the assumption that they are regulated by the Fed, even though they believed that secondary dealers that are regis~ tered broker-dealers are in fact more highly regulated than many primary deaiers. The panelists said that these trends ultimately could eliminate many secondary dealers ,that add capital to the market and service smaller institutions. They also arg~ed that regulation was needed to bolster confidence in­the market generally, although Mr. Clarke thought investor education might suffice in this regard.

Each panelist supported a different regulatory body. Mr. Kane favored regulation by the SEC, the NASD, and the bank regulators. Mr. Clarke favored Fed rulemaking because of the Fed's greater experience in the government securities markets. Mr. Barrett favored expansion of the MSRB to avoid creating a new board. Mr. Ogg favored a separate GSRB because of the differences between the government and municipal securities

- 6 -

markets. Their primary emphasis, however, was on the need for additional, uniform regulation rather than its form. They generally advocated giving the selected regulatory body authority to require registration, capital adequacy standards, inspections, and qualification standards. Mr. Ogg also supported fair practice and uniform delivery standards.

The panelists regarded the costs of such regulation as low, particularly in comparison to its value. Mr. Kane said the direct costs of registration requirements and qualifications standards for his firm would be minimal, as would the costs of SIPC contributions, if required.

The panelists indicated that they participated in Treasury auctions on an occasional basis. Their weekly secondary trading ranged from less than $1 billion (Clarke) to over $3 billion (Barrett). Their GNMA and agency security trading ranged from minimal (Kane) to 60% of total firm activity (Ogg). ~atched book operations ranged from none (Clarke, Ogg) to $300 million (Barrett). The majority of their individual repo trades exceeded $1 million (80% for Sarrett, most or all trades for others), although many of their cash market trades were' less than $1 million. (90% for Clarke, 30% for Ogg, 10% for Barrett).

Industry Group Panel: (Richard Kelly, PSA1 Robert Shapiro, SIA1 Rex Teaney, DBA)

The Public Securities Association ("PSA") stated that, although the government securities market has experienced recent problems that indicate a need for additional regulation, the government securities market is sound overall. In the PSA's view, the recent problems in the governmen~ securities market have resulted from careless and illegal actions by isolated dealers and irresponsible practices on the part of investors. The PSA believed that these problems have arisen mainly because of a regulatory gap that pe~mits approximately 150 to 200 government secu­rities dealers to be unregulated.

The PSA argued that regulation was needed to deal with these problems and to restore confidence and maintain capital in this market. The PSA proposed that specific rulemaking authority be granted to the Fed, applicable to all government securities dealers. This rulemaking authority should encompass: registration requirements, capital adequacy

- 7 -

standards, inspection and enforcement procedures, and rules or guidelines to prevent fraud in connection with repo transactions. The PSA wo~ld~vest enforcement and inspection authority in the regulatory authority that has principal oversight responsibility for the institution in question. Presently unregulated dealers would come under Commission and NASD oversight. The proposal would grant the Fed broad exemptive authority and the PSA emphasized that the Fed's rules should take into acc~unt the "unique role of the primary dealers."

The PSA supports the Fed as the proper regulatory authority because of its special interest in maintaining a healthy and viable market for government securities, its market knowledge, and its integrity. The PSA opposes the establishment of a separatE! self-regulatory organization for the government securities market because it believes that an SRO with general rulemaking authority would use its rulemaking authority to go beyond solving the problems that exist in the market.

PSA is opposed to mandating delivery of collateral in the repo market. It stated that delivery of collateral may, be costly, unnecessary, ,and impractical and that alternatives such as segregation of customer securities and third party ag reements ,exist and ~hould continue to be employed.

The PSA also favors the establishment of guidelines for investors in the government securities market and feels that this can be accomplished through the existing regulatory structure. It noted, for example, that ERISA guidelines provided sound guidance for investors.

The Securities Industry Association ("SIAn) supported the PSA's proposal on regulation of the government securities market, in order to preserve the efficency and the, integrity of the market; The SIA stated that all market participants should be subject to mandatory standards, with oversight authority to monitor compliance. It stated that unregulated government securities 'dealers are a small segment of the market. The SIA noted the need to balance investor protection against th~ liquidity needs of the dealers.

The SIA favois the Fed as the regulatory authority for the g9vernment securities market because the Fed would be sensitiv~ to the Tre~suiy's interests as the issuer of gover­nment securities and the need for efficient markets. The SIA opposed the'expansion of the MSRB because it feels the

- 8 -

government securities market is different from the municipal securities market and that the problems in the government securities market are easily identified and can be remedied. with specific rules.

The SIA opposed mandatory delivery of repo collateral. It supported capital adequacy guidelines, segregation of securities, recordkeeping requirements, and inspections to address the problem. Mr. Minike of Bear Stearns disputed estimates by Mr. Cleveland, stating that requiring delivery of an overnight repo might impose costs in excess of 300 basis points. The SIA noted that in many instances delivery of collateral is not practical and that, if the repo process is encumbered by too many restrictions, the Treasury will be subject to additional costs.

The Dealer Bank Association ("DBA") will not take an official position on the issue of regulation of the government securities market until its board meeting, June 5, 1985. Speaking personally, Mr. Teaney observed that: (1) some regulation of the market is necessary~ and (2) the Fed· should be given authority to regulate the government securities market.

Regulatory Pan~l: (Edward Geng, Federal Reserve Bank of N.Y.~ John Niehenke, Treasury Department~ Eric Bemel, Federal Bome Loan Bank eoard~ Christopher Taylor, Municipal Securities Rulemaking Board)

The regulatory agency panelists emphasized that the flow of capital to the government securities market must be protected. All the panelists agreed that a flight by investors from secondary to primary dealers would adversely affect the liquidity of the government securities market.

Mr. Niehenke said that the Department of Treasury had not yet reached a position regarding regulation of the government securities market. Be stated that the market had no inherent problems but was affected by transaction deficiencies. In response to these transaction problems, Mr. Niehenke noted that regulators and the accounting profession had promulgated guidelines concerning control and disclosure of collateralization. As a result, he stated that more investors are taking possession of securities, insisting on third party depositories, and scrutinizing balance sheets of dealers.

- 9 -

:',,,. . .. ~;." ..

Mr. Niehenke also raised concerns about over-in­clusiveness in the definition of ,government securit'ies'" dealer. Be asserted that many of the proposed regulatory" .. " schemes would unintentidnally include small thrifts, mort~age bankers, and money brokers dealing in government securities transactions. Be argued that regulation of these sectors might drive these investors to other securities markets.

Mr. Bemel noted that the Federal Bome Loan Bank Board's . (·FBLB") constituen.t.#5. were the primary victims of recent failures of government secur.1ties dealers. Be said ·.that·- .-.. ' ..... . the FBL2 was currently lookiri~ at means of ensuring that its participating constituents complied with already existing FBLB guidelines concerning government securities transactions, and that the FBLB is considering adding additional guidelines.

Mr. Geng indicated that the Fed had not yet reached a conclusion regarding the need for additional regulation of the government secuurities markets. Be noted that neither collateralization nor third party delivery were complete solutions and that various regulatory opitons pose different problems. Mr. Geng believes that educating the participant~ in the government security market was a useful approach to the problem. .

2/·

Be listed six such guidelines issued by the FELB th~f affect savings & 10.an associations ("S&Ls·). These .. :.:;;,' guidelines recommend that S&Ls (1) know the dealer . before engaging' in any government securities trans­actions,·.( 2) inspect the certified financial statements and other filings required by any agency that regulates"" the dealer, .( 3) do a credit analysis of counterparties, (4) use capital' adequacy guidelines in choos·ing dealer'si;" (5) ensure that counter-collateral exists, and (6) review repurchase ag reements to see if the market value of' ". ,.i" collateral exceeds funds received.

Such guidelines will require S&Ls to (1) use a third party depository arrangement, (2) recalculate the value' of their collateral on a weekly basis, (3) deal only ..... with dealers who are regulated broker-dealers, (4) . ensure that the value of the collateral they receive is at least equal to the value of the loans made, and (5) make payment or purchase goverment securities at the same time they receive confirms by third parties.

"'.' "w'

4 / I/

- 10 -

Christopher Taylor declined to comment because the MSRB is scheduled to testify at the Energy and Commerce Committee hearings on June 11, 1985 (since postponed).

Impact of Recent Events on Government Securities Markets

Mr. Niehenke indicated that he had seen no evidence of an investor shift from Treasury Bills or repos to other kinds of securities as a result of recent events. Be conceded that investors were changing methods of trans­acting business, but he characterized these changes as merely evolutionary. Be therefore concluded that there was no disturbance of the basic government securities market. Mr. Geng disagreed with Mr. Niehenke's view and stated that, while there was no short term problem, he was concerned that investor flight to primary dealers could ultimately result in withdrawal of capital from the market.

Mr. Niehenke noted that, even if repo agreements became less available as other panelists had said was occ~rring, dealers still could use other means to finance their govern­ment securities businesses. Be also argued that inyestors could protect themselves without regulation by either taking possession of securities or perfecting their interest in the securities. Mro Niehenke argued that regulation could have adverse effects if it identified participants incor­rectly or drove some participants out of the market.

°Mr. Niehenke stated that the international currency market had responded negatively to the failure of ESM (and the subsequent collapse of the Ohio private bank insurance system). Be added that the decline in the value of the dollar reflected the international market's misunder­standing of the effects on the United States banking system of the collapse of a few financial institutions.

Causes of government securities dealer failures

Mr. Geng stated that double collateralization was one of the primary causes of the recent dealer failures. Be added that, in both ESM and BBS, investors suffered sub­stantial losses of margin payments made to those firms. In addition, he observed that falsification of records by dealers and false certified financial statements contributed to the problem. Mr. Geng also added that if these problems were resolved, new fraudulent methods could be devised such as abuse of custody or when-issued trading arrangements. Be· concluded that to avoid fraud one must educate participants in the marketplace, create good internal industry guidelines, and invest prudently.

- 11 -

When-issued Trading

Mr. Geng said that both the Treasury and the Federal Reserve had examined the when-issued market to prevent problems. In response, the Treasury had shortened the when-issued auction period from three weeks to a maximum of two .weeks. Also, dealers have improved internal credit checks of counter-parties and taken other steps to reduce their monetary exposure. Be noted, however, that credit checks are a problem when multiple parties are involved • . Beadded tha~ the Federal Reserve is collecting data from primary dealers concerning their exposure on when-issued accounts.

Nonetheless, Mr. Geng stated that the when-issued market continues to be an area for possible abuse since an unscrupulous party could build up excessive positions at considerable risk

·to its counterparties.